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Critically Evaluate The Use Of Current Theories For Explaining Why

Business Groups Are Common In East Asia.


Business groups are a common feature of many emerging economies, especially East Asian
Economies where the mix of poor financial infrastructure, market regulation and the underlying
culture foster the growth of these business groups (Khanna and Yafeh, 2005). Previous research
has shown that the expansion of these groups has aided poorly developed countries in Asia,
leading to a period of rapid growth in mid to late 20
th
Century, coined The East Asian Miracle.
Their prevalence within Asian economies is discussed by Chang (2006), who shows that in Korea
in 1996, the top 30 chaebols accounted for 40% of output in the mining and manufacturing sectors
and 14% of GNP. This similar trend can be seen throughout East Asia. The presence of business
groups is made more significant when we investigate the structure and performance of these
entities. Khanna and Yafeh (2007) show that in emerging markets, group affiliated firms are larger
than unaffiliated firms with these affiliated firms outperforming others in terms of profits, for
example, Chinas national champions subsidiaries achieve profits around 20% greater than
independent companies (Guest and Sutherland, 2010). Therefore the important questions that will
be addressed by this essay are, what are the key features of business groups and why do they
form?

Defining a business groups has become a contentious issue, with definitions varying from the
vague: legally independent firms who are bound together in some way (Carney, 2008, p. 5), to
the more specific:

a group of companies that does business in different markets under a common
administrative or financial control linked by relations of interpersonal trust, on
the basis of a similar personal, ethnic or commercial background
(Leff, 1978, p. 663)

Whilst economists disagree on the finer points of the definition, for example whether or not a
family aspect is required to differentiate between a business group and conglomerates (Almeida
and Wolfenzon, 2006), they agree that unrelated diversification and common control are defining
characteristics, with difference in structure due to the variation of economic conditions (Hainz,
2007).

Literature on business groups outlines a wide range of reasons for their formation. Many of these
reasons shine a positive light on their development, for example, they are used to overcome the
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institutional void that is found within emerging economies. However, a number of authors argue
that they also form so as to take advantage of the monopoly position it affords them, to use the
group structure to tunnel resources between firms and also to facilitate rent seeking. This essay
will first assess the positive reasons for formation and then analyse the negative reasons that raise
suspicion about the formation of groups.

Businesses in advanced economies rely on a range on institutions to provide accurate information
about capital, product and labour markets, along with providing regulation and an efficient judicial
system. Unlike advanced economies, emerging markets suffer from weak institutions in all or
most of these areas. Differences in institutional context explains the success of large, diversified
corporations in developing economies such as East Asia and their failure in advanced economies
such as the United States and the United Kingdom (Khanna and Palepu, 1997). Many believe that
where markets are imperfect and regulatory institutions are poor, affiliation with business groups
will enhance a firms performance (Carney, 2008).
Emerging markets often experience underdeveloped capital markets with a scarcity of
intermediary financial institutions, such as equity markets and bond markets. This presents
problems for both firms who wish to raise capital for projects, and firms with excess cash as it
provides limited options for reinvestment (Carney, 2008). Without access to information, investors
refrain from putting money into unfamiliar ventures. In such a context, diversified groups can
point investors to their track record of returns, thereby developing a reputation. They are also able
to use their internally generated capital to grow existing businesses and act as lending institutions
to existing members that are otherwise too small to obtain capital from financial institutions.
Therefore business groups are often structured around a central financial institution or bank that
distributes capital throughout the chain of businesses (Khanna and Palepu, 1997). This practice is
evidenced by the Tata group. In 1982 the group created Tata industries, a venture capital vehicle
funded with a special pool of investment money drawn from member companies. It has provided
seed money to several successful ventures, including two computer-manufacturing enterprises.
Most emerging markets suffer from a scarcity of well-trained people. While the United States has
more than 600 business schools training thousands of future managers every year, Thailand, for
example, has only a handful of high-quality business schools that produce far fewer entry-level
managers than the economy needs (Khanna and Palepu, 1997). Thus, diverse and powerful
business groups provide an internal market for highly trained individuals who can be distributed
throughout the firm to where they will be most productive. This creates much-needed flexibility as
evidenced by Gerlach (1992), who notes that a feature of Japanese business groups is the
dispatching of senior management to aid affiliates with certain projects, i.e. new venture start-ups.
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In the case of product markets, buyers and sellers usually suffer from a dearth of information due
to the lack of communication infrastructure. Equally significant, when information about products
does get around there are no mechanisms to corroborate the claims made by sellers (Hainz, 2007).
As a result, companies in emerging markets face much higher costs to build credible brands than
their counterparts in developed economies. In turn, established brands wield tremendous power
and can enter new businesses even if they are completely unrelated to its current lines, spreading
the cost of building their brand through multiple lines of business (Khanna and Palepu, 1997). The
Korean chaebols are famous for extending their group identity over multiple product categories,
with Samsung providing a good example of a business group that has been able to develop quality
products and enter a wide range of markets.
Business groups also develop so as to act as mutual insurance mechanisms, suggesting that
affiliation with a business group allows affiliates to share risk by smoothing income flows
between firms and coming to aid in times of crisis, thus reducing the risk of bankruptcy (Carney,
2008). Income smoothing is achieved by channelling resources from stronger and more profitable
firms to underperforming firms, thereby propping up their troubled affiliates. These mechanisms
carry benefits as they reduce the firms cost of capital and may also encourage firms to undertake
projects that independent firms would not be able to (Khanna and Yafeh, 2005).
Emerging markets have often been described as industrial latecomers, located in countries far
from centres of science and technology. The initiation of a growth cycle usually begins with firms
acquiring intermediary technology, which may not be state of the art but represents a significant
improvement over local competitors (Carney, 2008). Developing states seek to shelter these
enterprises from the effects of foreign competition by creating artificial barriers to entry and direct
financial support. Cash-rich business groups simultaneously fill institutional voids, pool scarce
capital, and acquire technology and management expertise that can be utilised to establish itself as
an oligopolistic domestic player in a capital-intensive 'mid-tech' industry (Amsden, 1994).

Unfortunately, there are a number of negative reasons for the formation of business groups in East
Asian economies. Business groups are widely criticised for the ownership structure that is at the
core of their development, organised with the controlling minority structure, providing full control
right to a shareholder with only a small fraction of equity. Minority control is achieved using
structural devices that include dual class share structures, cross ownership ties, and most
commonly a pyramidal structure (Carney, 2008). Pyramids let dominant owners magnify their
control rights beyond their cash flow rights and leverage their relatively small personal wealth into
control over corporations and assets worth vastly more. These structures allow the extraction of
value from minority shareholders by granting high or low interest rate loans, manipulating transfer
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prices, or inflating charges for intangibles. These processes are described as tunnelling or abusive
related party transactions, transferring value from one firm in the pyramid to another (Almeida and
Wolfenzon, 2006). A report commissioned by the OECD in 2009 highlights this issue with the use
of the Indian Satyam Computer Services case study. On December 16
th
, 2008, the board of
directors of Satyam approved the acquisition of Maytas Properties and Maytas Infrastructure for
$1.3 billion and $300 million, respectively. Maytas Properties and Maytas Infrastructure were
entities related to B. Ramalinga Raju, the founder and chairman & CEO of Satyam, raising
concerns over valuations of the two entities, the timing, and method of payment. These concerns
led to greater scrutiny of Satyam by investors, revealing a $1 billion accounting fraud, concluding
in the resiging of Raju as he admitting that for the past several years he had been inflating cash
reserves and overstating revenues (OECD, 2009).
Further to the formation of pyramid structures, business groups use their superior position to
develop monopoly power within the market. Policies in emerging markets often emphasise import
substitution and export led development, protecting domestic firms from international
competition. Carney (2008) discusses how these industrial policies not only protected the East
Asian domestic firms from international market pressures, but also provided power to politicians
who could decide which companies would receive the most support, through quotas and subsidies.
The success of a firm depended more upon their rent seeking capacity to access and influence
politicians, and less upon managerial and technological capabilities. It was this crony capitalism
in the government that gave many business groups the opportunity to grow and take advantage of
the markets in which they operated.

I believe that the reasons that are discussed in this essay go some way to provide the reasoning
behind business group formation; it is not possible to single out one key factor that has caused
such a concentration of these groups in East Asia. Steers et al. (1989) argue that the influence of
cultural family relationships has shaped the development of these groups, with 31% of executive
officers in the top twenty South Korean chaebols being family members. Other authors argue that
the process is a purely a result of the institutional void. With time, as we see the rest of East Asia
reach western levels of development, Ahmadjian (2008) argues that there will a diminishing
influence of business groups in the economy, as is seen with the withering away of the Japanese
Keiretsu. When market institutions have evolved such that there is better legal protection, more
capital available and better financial intermediaries, there will be less need for internal group
markets and broad levels of diversification in business groups (Hoskisson et al., 2005). In
conclusion, I have to agree with Khanna and Yafeh (2007), who state that the formation of
business groups remains largely unexplained (p. 362).
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Reference List

Ahmadjian, C. (2008) Japanese Business Groups: Continuity in the Face of Change, in Business
groups in East Asia, (pp. 29-51), New York: Oxford University Press

Almeida, H. and Wolfenzon, D. (2006) A Theory of Pyramidal Ownership and Family Business
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Amsden, A. (1994) Why Isnt the Whole World Experimenting with the East Asian Model to
Develop?: Review of The East Asian Miracle, World Development, Vol. 22, No. 4, pp. 627-633

Carney, M. (2008) Asian Business Groups: Context Governance and Performance, Oxford:
Chandos Publishing

Chang, S. (2006) Business groups in East Asia: Financial Crisis, Restructuring, and New Growth,
Oxford: Oxford University Press

Gerlach. M. (1992) Alliance Capitalism: The Social Organisation of Japanese Business, Berkeley:
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Guest, P. and Sutherland, D. (2010) The Impact Of Business Group Affiliation On Performance:
Evidence From China's National Champions, Cambridge Journal of Economics, Vol. 34, No. 4,
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Hainz, C. (2007) Business Groups in Emerging Markets: Financial Control and Sequential
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Khanna, T. and Palepu, K. (1997) Why Focused Strategies May Be Wrong For Emerging
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Khanna, T. and Yafeh, Y. (2005) Business Groups and Risk Sharing around the World, The
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Khanna, T. and Yafeh, Y. (2007) Business Groups in Emerging Markets: Paragons or
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OECD Report (2009) Guide on Fighting Abusive Related Party Transactions in Asia

Steers, R., Shin, Y. and Ungson, G. (1989) The Chaebol: Korea's New Industrial Might, New
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