How China Copied South Korea All Wrong

By Shuli Ren

February 22, 2021, 6:00 PM EST

Lotte group chairman Shin Dong-Bin bows in apology during a press conference at the Lotte hotel in Seoul on August 11, 2015.

Are you trying to figure out which companies to bet on in China? Here’s a word to watch out for: jituan, Chinese for business group or conglomerate. If you see a Chinese conglomerate coming, it’s probably best to run in the other direction.

The country’s biggest and most recent corporate busts often involve entities with jituan in their names. Beijing is spending billions to clean up HNA Group Co. and Anbang Insurance Group Holdings Co. — the first, a globe-trotting profligate, the second, a high-flying fraud now in liquidation. Peking University Founder Group Corp., which is entangled with fugitive billionaire Guo Wengui, is restructuring its debt in a court. Last September, Asia’s junk dollar bond market was abuzz when a letter purportedly from China Evergrande Group warned of cash crunches at the company, the world’s most indebted real estate developer. Evergrande said the letter was fake but its allegations fed existing misgivings about the company. To defuse the crisis, chairman Hui Ka Yan had to convince investors to rollover about two-thirds of Evergrande hybrid securities worth 130 billion yuan ($20 billion) due in January.

The most tumultuous of last year’s ugly wave of bond defaults by state-owned enterprises — the biggest in modern China’s history — all came from industrial conglomerates. Among them, Yongcheng Coal & Electricity Holding Group Co. and Brilliance Auto Group Holdings Co., the largest state-owned enterprises in Henan and Liaoning, their respective provinces. Tsinghua Unigroup Co., a commercial arm of the prestigious Tsinghua University and an integral part of President Xi Jinping’s dream of semiconductor supremacy, defaulted on $2.5 billion worth of dollar bonds in December.

China’s stock market provides another clue for concerned investors, specifically involving the smaller conglomerates that have received regulatory nods to go public. About 15% of the companies classified as such carry the tag “ST,” or “special treatment” from the exchange. It’s not coddling but finger-wagging — a way the bourses issue delisting warnings to companies that have incurred at least two consecutive years of operating losses. Only 4% of the broader market get the “ST” treatment, data compiled by Bloomberg shows.

So what’s wrong with the country’s biggest businesses? You can describe it as a failure of imitation by a country that has often been called the great imitator. When Chinese companies copy well, you can often expect world-beating innovations down the line. In the case of conglomerates, Chinese companies want to be like South Korea’s chaebols — the enormous diversified corporations that are mostly controlled by a single family under extensive but efficient ownership structures. So far, the reproductions are far from faithful.

The Chaebol Ideal

There’s good reason for China to admire the Korean model. Chaebols perfected the art of managing sprawling corporate empires. The founding family of a chaebol sets up layers of holding companies, at each level owning more shares than any other single entity and benefiting from that influence to exercise control, using relatively small percentages of stock to control crown jewels multiple-times bigger. For example, here’s the capital-efficient way SK Group retains its grip on semiconductor manufacturer SK Hynix Inc, its most valuable asset. The Chey family has about a 25% stake in SK Holdings Co, which owns 27% of SK Telecom Co. The telecom, in turn, has a 20% stake in the chipmaker. And so, with just $4.6 billion worth of shares, the family has the $91 billion Hynix at its command.

Kim Seung-youn, chairman of Hanwha Group, from left, Chey Tae-won, chairman of SK Holdings, Jay Y. Lee, co-vice chairman of Samsung Electronics, Shin Dong-bin, chairman of Lotte Group and Cho Yang-ho, chairman and chief executive officer of Korean Air, attend a parliamentary hearing at the National Assembly in Seoul, South Korea, on Dec. 6, 2016. — Executives of Hanwha Group, SK Holdings, Samsung Electronics, Lotte Group and Korean Air at a parliamentary hearing, 2016. *SeongJoon Cho/Bloomberg*

The Lee family uses the same method to control flagship Samsung Electronics Co. The family’s direct holdings in Samsung Electronics is a tiny 5%. Korea’s National Pension Service is its single largest shareholder at 10.8%. But the Lee family remains in the driver’s seat, mostly through the total 13.5% stake held by Samsung C&T Corp. and Samsung Life Insurance Co. The Lees have controlling interest in both.

As complex as Korean chaebols are, they are far more transparent than Chinese conglomerates. The founding families’ incentives are simpler and mostly devoid of the geopolitical ambitions that motivate many of China’s biggest businesses. And despite their role in South Korea’s economy, chaebols are not beyond scrutiny. Their dynastic feuds have inspired television soap operas. More importantly, the plurality holdings they use for tax benefits and control may be subject to reform. Over the past few years, President Moon Jae-in’s government has strengthened the tax code and enacted the Fair Trade Act to improve corporate governance.

In contrast, China’s would-be chaebols are studies in opacity.

The Wrong Kind of Ambition

China’s pursuit of great power status is a key reason for the failings of some of its biggest conglomerates. Often, they aren’t motivated by business but, say, the goal of global microprocessor dominance. And they have to take on debt to do so. That’s a pretty big impediment if the profit-oriented chaebol is your model.

Tsinghua Unigroup is a Samsung wanna-be. The semiconductor empire with close to 300 billion yuan ($46 billion) in assets has 286 consolidated subsidiaries. It used a chaebol-like strategy to get hold of the cutting-edge flash-memory chipmaker Yangtze Memory Technologies Co. for cheap.

If you look at registered capital, or initial money spent, Unigroup should not be the proud owner of YMTC. That honor should belong to the state-owned China Integrated Circuit Industry Investment Fund, set up in 2014 to further Xi’s Made in China 2025 microchip aspirations. In December 2016, through direct and indirect holdings, the Big Fund — as China Integrated is nicknamed — contributed 49% of the initial capital in YMTC. Unigroup invested only 13%. But since Unigroup has more than a 50% stake at each level of YMTC’s ownership tree, it gets to control everything.

Sources: Company filings; Dongxing Securities

Unigroup also benefits from the fact that the Big Fund follows a venture capitalist model, which usually precludes participation in the daily operations of any start-up. It’s a convenient way of distancing the government from U.S. accusations that Beijing was supporting its nascent domestic chip industry with unfair and protectionist economic policies. The Ministry of Finance, which implements China’s fiscal policies, is the Big Fund’s largest shareholder.

State ownership of Unigroup, on the other hand, can only be traced up to the Ministry of Education, which runs Tsinghua University, a public institution of higher education much like the University of California, Berkeley. Tucked seven layers down Tsinghua’s towering family tree, YMTC easily stayed out of the media limelight and the U.S.-China rumble. Funded through private bank loans and cash transfers from its parent, the chipmaker did not have to ask public markets for money — thus, much of its finances were beyond scrutiny.

The privilege of owning YMTC has taken a heavy toll on its parent. Developing chip manufacturing is terribly expensive, and YMTC’s 56 billion yuan of registered capital was just seed money. Unigroup has earmarked $24 billion in total spending there. The project was operating at a loss in 2019. As of June, YMTC owed over 7 billion yuan in loans to China Development Bank, all guaranteed by Unigroup, company filings show.

Chips by Tsinghua Unigroup at the 2020 World Semiconductor Conference in Nanjing in China’s eastern Jiangsu province on August 26, 2020. — Chips by Tsinghua Unigroup, 2020. *STR/AFP via Getty Images*

Unigroup is also saddled with debt it took out for other subsidiaries — many also exempted from making public financial disclosures and whose debts are ultimately the responsibility of the group holding company. As of June, Unigroup had 46.7 billion yuan of borrowings due within a year, with more than half owed to bond investors. It sat on only 42 billion yuan of unrestricted cash, and was bleeding from massive capital expenditure. In December, Unigroup failed to repay a $450 million dollar bond, triggering cross-defaults worth $2.5 billion. The company has not been able to tap into public bond markets since March 2019 and has another $1.05 billion dollar note due at the end of January.

On a consolidated basis, the net debt-to-equity ratio of the conglomerate and all its subsidiaries stood at 125% as of June — high but manageable. But leverage at the holding company level is almost ten-fold, with only 5.1 billion yuan of cash on its account. It is no wonder Unigroup could not find the money to repay the $450 million dollar bond in December.

China’s opaque socialist society can make the corporate labyrinths become even more twisty. Unigroup has good assets in publicly-listed subsidiaries Unigroup Guoxin Microelectronics Co., which designs chips used in smart cards, and Unisplendor Corp., which does cloud computing. But the subsidiaries did not come to the holding company’s rescue, in spite of the chaebol-like ownership structure. Unisplendor only agreed to buy the holding company’s 46.67% stake in unlisted UniCloud’s business for 1.9 billion yuan after Unigroup defaulted on the dollar bonds. Perhaps the price did not make good business sense: Unigroup sold UniCloud at 5.7 times book value. In a filing, Unisplendor said the deal was meant to help it become a platform services provider.

To be fair, conglomerates sometimes re-shuffle their ownership structure not to shirk from creditors, but to keep those trophy projects alive to fight another day. For instance, if Unisplendor had not taken over Unigroup’s stake in UniCloud, the cloud services business — which is still in the red — would have had to wind down. That would not be a good look in China’s march toward big tech domination.

Red Lines and Loopholes

Debt fuels China’s economic growth — and access to more borrowings often provides companies with a competitive edge. But debt also weighs on corporate finances and draws the attention of regulators. Some big businesses have resorted to “back doors” to hide ballooning debt and escape scrutiny.

Joint ventures are those back doors. They aren’t really part of corporate layering because they ostensibly are outside entities. They allow conglomerates to enter new markets by lending their prestige to other corporations. But they also contribute to the lack of transparency. As the downfall of Wirecard AG has shown, joint ventures can be convenient tools for accounting shenanigans. The German fintech firm used allegedly fraudulent partnerships in Dubai and the Philippines to inflate sales numbers — impressing unsuspecting investors back home.

China’s real estate sector is full of joint ventures. In 2019, developers tracked by S&P Global Ratings on average received 35% of their contracted sales from unconsolidated entities, compared with just 23% in 2017. On the face of it, developers have legitimate reasons to form joint ventures. Through such partnerships, they can reduce project risks and bid for multi-billion-dollar land sales that they otherwise couldn’t undertake on their own. But it’s also a clever way to pretty up a balance sheet.

Financing has been tight since late 2017 when Beijing launched a corporate de-leveraging campaign in earnest. The enforced diet escalated last August when the government imposed its “three red lines.” Developers exceeding the trio of leverage metrics monitored by regulators are forbidden from borrowing more. But here is the caveat: They are not required to disclose financial details on joint ventures where they hold only minority stakes. They can pile up debt there and avoid the red lines.

That’s a recipe for nasty surprises. Often, developers provide the financial guarantees for their joint ventures’ borrowings, which means, ultimately, they are on the hook if the projects fail. These aren’t evident because these partnerships aren’t consolidated till late in the process. So that sudden jump in leverage you’re shocked at now? It has been years in the making.

In 2017, Shanghai-based Greenland Holdings Corp. saw its reputation take a hit after a joint venture in northeast Liaoning province failed to pay 457.5 million yuan of loans on time. Greenland didn’t guarantee the loans but had to deal with a market that finally perceived how shady that Liaoning joint venture was. To save face, Greenland had to absorb the losses and, by doing so, crossed all three red lines. It’s been losing market share since.

Layers of Mess

The layering effect can create a corporate family tree so tangled it’s practically a forest. That encourages bad governance — and those who thrive from it. It’s also the perfect kind of conglomerate structure that can shield quality assets from getting into the hands of creditors.

Last September, about a month before its default, Brilliance Auto Group Holdings Co., the largest SOE in Liaoning, transferred its stake in a successful joint venture with BMW AG to another subsidiary. It subsequently pledged those shares as collateral to “an independent third party” for loan facilities. In other words, if the creditor thought it could get some money back from an entity, that party then turned out to be something else even farther out of reach. A huge outcry emerged from China’s activist investors and, in late December, the automaker finally released the pledged shares.

German Chancellor Angela Merkel and Chinese Premier Li Keqiang look on as Qi Yumin CEO of Brilliance Auto Group and Harald Krueger, CEO of German car maker BMW sign a letter of intent on Electric mobility at the Chancellery in Berlin on July 9, 2018, as part of Germany-Chinese government consultations. — CEOs of Brilliance Auto and BMW sign a letter of intent in Berlin, 2018. *Omer Messinger/AFP via Getty Images*

And then there are the complete structural messes — where you can’t see the forest for the trees and vice versa. Almost a year ago, a Beijing court took on a creditor’s application to start the restructuring process for Peking University Founder Group, a commercial arm associated with the prestigious state-run university (and rival to Tsinghua). The local court accepted Founder’s paperwork quickly. The restructuring work was directed by the People’s Bank of China, the central bank.

Since then, there’s been little progress. The Beijing court has had to handle complex issues such as whether to accept keepwell clauses, an obscure type of gentlemen’s agreement almost akin to guarantees. There are other complications. Founder claims a property developer controlled by Guo Wengui owes it 14 billion yuan in unpaid bills. That issue cannot be resolved because the billionaire is now a fugitive, making news while partying in the U.S. on a yacht with Steve Bannon in August 2020.

More Reform Please

As my colleague Brooke Sutherland wrote recently, U.S. conglomerates weren’t considered good investments for decades. But recently, a heightened sense of competition and sharper focus on profitability have improved their reputations. Their counterparts in China have to turn things around, too. It won’t be easy.

Chinese conglomerates can’t be entirely blamed for their financial woes. Beijing’s frequently fluctuating credit cycles must shoulder a lot of the responsibility. Money was too easy in 2016, then too tight in 2018. In 2020 alone, the PBOC did a full 360-degree turn, first flooding banks with cash and then tightening, evidenced by a V-shaped rebound in the 10-year sovereign bond yield.

State-affiliated holding companies have a modus operandi for the cycle. They sell bonds by impressing the public with too-big-to-fail scale and the glittering assets of its subsidiaries. The game continues until the day the PBOC begins tightening again. Then there’s no money to be borrowed to keep things going — and companies go bust.

Investors are starting to understand the pitfalls of this game — and to distinguish between a conglomerate’s consolidated balance sheet and its stand-alone financials. It’s the holding company who issues the debt and it’s those financials that matter — not the more salubrious-looking assets of the subsidiaries. Sooner or later, investors will know to run when they see a jituan coming.

China has been talking up regulating financial holding companies, worried about the systemic risks they might pose. It may have been that concern that led to the clampdown on Jack Ma’s potentially dominant fintech unicorn Ant Group Co. — a jituan that aspired to process most of China’s digital payments, lend to hundreds of millions of consumers and small businesses, manage their wealth and write insurance on their uncertain futures. It was hugely ambitious — and deeply concerning to the PBOC. New regulations on financial holding companies published last September were aimed straight at Ant and designed to restrict financial conglomerates’ leverage ratio, intra-group transaction and their ever-expanding ambition across regions and business offerings. When Ant persisted with its $35 billion IPO, the government cracked down.

Employees walk through the campus of the Ant Group Co. headquarters in Hangzhou, China, on Jan. 20, 2021. — Ant Group headquarters, January. *Qilai Shen/Bloomberg via Getty Images*

But non-financial holding groups need to be reined in, too. Their ambitions aren’t any smaller than Ant’s. Unigroup has a presence throughout the entire semiconductor value chain, from design, to manufacturing, all the way to cloud services. When does all this leveraging and expansion end? When does profitability begin? And what happens if several of these hugely indebted conglomerates fail in quick succession?

National ambitions are important but if they are tied to business, those enterprises must be viable and not self-consuming. There is a legend out of India of a lion so voracious that he eats his own legs, torso and everything up to his lower jaw. Only his huge fangs and a gaping mouth remain. China does not see this as a danger. It wants all its trophy conglomerates and champions to succeed. But in the end, it may end up with nothing — and be on the hook for everything.

How China Copied South Korea All Wrong

Chinese Bond Defaults, 2020

Delisting Danger

The Chaebol Ideal

The Korean Model

The Wrong Kind of Ambition

The Chinese Copycat

Red Lines and Loopholes

Layers of Mess

More Reform Please