South Korea’s massive shipbuilding industry, the world’s leader, is facing a crisis, with the country’s three largest shipbuilding firms reporting combined losses of W6.4 trillion (US$5.5 billion) in 2015 alone in offshore plants as the shipping market has deteriorated and world oil prices have plunged, resulting in a fall in new contracts.
The industry is facing restructuring after the failure to cope with the crisis, but with numerous stakeholders and sizeable financial transactions, restructuring is bound to be slow and on a large scale.
Numerous issues have arisen, such as whether state-owned banks should provide financial assistance, who is responsible for, and how to prevent the inevitable increase in the number of unemployed and the downturn in the local economy.
The business cycle of Korea’s shipbuilding industry is long, its mountains high and its valleys low. Its peaks have come in cycles of 20 to 30 years in the 20th century: during the two World Wars, in 1973, and in 2007. After the 2008 Global financial crisis, tens of South Korean small- and medium-sized shipbuilding firms disappeared, leaving only the medium to large firms.
The failing shipbuilding industry, however, seemed to have been rescued thanks to worldwide quantitative easing and China’s relatively strong growth. Shipping companies returned to shipbuilding firms to purchase ships at lower costs. Deep sea oil-and-gas drilling boomed as oil prices soared to over US$100 a barrel. Shipbuilding firms won new contracts of ships and offshore plants building, which contributed to their growth.
In 2013, companies signed the second-largest number of ship contracts in history, intensifying the oversupply of ships. Oil prices, meanwhile, plunged as the structure of the energy industry changed from 2014, due to US mass production of shale gas and oil. These two factors – an oversupply of ships and the drop in oil prices – contributed to a sharp decline in new contracts.
The number of new contracts for South Korean shipbuilding firms from January to May 2016 decreased by 95 percent year-on-year. The three largest firms reported combined losses of a whopping W6.4 trillion in 2015 alone in offshore plants. The problem here was low-priced contracts combined with insufficient capabilities.
Europe and Japan went through large-scale shipbuilding restructuring for 20 years after the oil price shock in 1973 ended the hyper-boom in the shipbuilding industry. Now, many say that it is South Korea’s turn to undergo restructuring. Tears of Malmö, the extra-large crane sold to Hyundai Heavy Industries for a single dollar, epitomized the downfall of the Swedish shipbuilding industry. It seems that the fear of this situation becoming the Tears of Ulsan may soon be realized.
Restructuring Progress to be Slow
Shipbuilding industry requires huge sums of capital. It takes two to three years from contracting a ship to completion. Within this period, multiple large-scale financial transactions are made. The ship owner pays prepaid expenses to the shipbuilding firm and requests refund guarantees (RGs) for those prepaid expenses from a financial institution as a kind of insurance policy. Financial institutions provide financial assistance such as funds for equipment, production, and operations, as well as engaging in foreign exchange hedging.
Large-scale financial transactions are inevitable until contracted ships are delivered. It is not easy to halt this process, once a financial institution is involved, because shipbuilding firms build only a specific number of ships at the same time. Moreover, financial institutions will minimize their losses if they end their business with a shipbuilding company only after completion of construction, as opposed to allowing a firm to go bankrupt during the construction process.
Thus, shipbuilding firms don’t normally enter bankruptcy proceedings, even if business is slow. Ship owners want their RGs to be issued by financial institutions that have the same credit ratings as sovereign credit ratings, resulting in state-owned financial institutions issuing most of the guarantees. The objectives of state-owned financial institutions are not limited to normal financial transactions; the promotion of industry is also among their objectives. This makes it harder to expect swift restructuring.
Other stakeholders exist in the shipbuilding industry including ancillary industries and jobs. As a result, downfall can lead to tragedy for a whole city. This is why the central government, local government, and political circles in general consider the industry to be important. Restructuring is difficult because the government hopes to insulate the local economy from the shock of increasing unemployment and insolvent equipment and materials manufacturers. Thus, if a plan for recession is not prepared and shared, it is natural that restructuring seems to be slow.
The biggest question remains: Is there a need to provide massive amounts of funds via state-owned financial institutions in an uncertain industry? People are concerned that capital that would otherwise be invested in businesses for new industries or growth might be needlessly wasted. Moreover, in the case of Daewoo Shipbuilding & Marine Engineering (DSME), one of the most insolvent companies, investigations are ongoing regarding fraudulent accounting and management corruption. Public sentiment is hostile to the idea of supporting such enterprises with serious moral hazards.
The technical knowledge and skills of the human resources in South Korea’s shipbuilding industry are recognized as the best in the world. On the basis of that, some experts argue for support for the industry in order to maintain that competitiveness, and to prepare for the next economic boom. They base their argument on the situation in the 1980s: Japan, then the top shipbuilding country, lost excellent human resources and facilities with large-scale restructuring. In contrast, South Korea continuously trained talented individuals and expanded facilities, even during difficult times, allowing it to become the current great shipbuilding power as it is.
Surely, there are predictions that Japan’s shipbuilding will recover. However, with a shortage of facilities and human resources, it seems difficult to forecast a drastic improvement in competitiveness.
Corporate management can only pursue short-term achievement. In a made-to-order production industry, contracts appear as immediate results, while financial performance emerges later. As a result, orders have been overly promoted, and then appeared as large-scale deficits after several years. Shipbuilding companies have also got to experience what the South Korean construction world (another made-to-order production industry) experienced in plant construction. This is the basis for the argument that it is not reasonable for laborers to be held solely accountable for management failures, and that management should take the bulk of the blame.
There are additional issues: even among laborers, there are disputes about whether only non-regular workers experience serious negative consequences.
The Need for a Fair and Strong Agent
Currently, restructuring is proceeding through cooperation between the government and creditors. Recently, the South Korean government initiated a ministerial-level council to address industrial competitiveness, and mediate between various stakeholders and strengthen oversight and control of the process.
On the other hand, there are also arguments that the government and state-owned financial institutions are not qualified for being the restructuring agent, because they neither prevent small- and medium-sized shipbuilding firms from mushrooming in the past, nor sold the DSME at the appropriate time.
There is also criticism that the government and national banks should be held responsible for DSME’s weakening performance and fraudulent accounting.
The main agent in restructuring should embrace the various stakeholders, and create and implement rational alternatives. It should be a fair organization with authority. It needs not only to clarify who is responsible for insolvency and persuade people of that, but also to allocate resources, adjust facilities and human resources, maintain competitiveness in shipbuilding, and foster future technology. It should draw the larger picture of the future, and not be busy deciding the proper size of facilities or restructuring individual firms.
Need for Proper Risk Management
Support for the shipbuilding industry is not an issue of right and wrong, since results change according to prospects. And if the shipbuilding industry is not given up, we might encounter such a problem again. Therefore, we need to come to a social consensus, based on future research.
But is it possible to predict the future? Maritime economics expert Martin Stopford has said that shipping and shipbuilding are far too complex and forecasting their future is close to be impossible. Forecasting is uncertain, and the size of the shipbuilding industry is big. Risk is a combination of uncertainty and gravity, and the current risk-level of South Korea’s shipbuilding industry is extremely high. Albeit belatedly, now is the time to reemphasize the importance of risk management.
With a growth-oriented vertical organization, South Korea established itself as the world’s best shipbuilding country in a short time. However, in such a culture, risk management is not so easy. Firms should properly establish a firm-level risk management process, just as the advanced engineering firm, Bechtel, has done. They should establish and strengthen a system that makes such diverse divisions as sales, business, and support cooperate transparently, and controls risks very well.
The government should establish a horizontally-structured standing organization with the power to mediate among stakeholders. Experts who understand the complicated characteristics of the shipbuilding industry should be included, and the organization should continuously research the future and risks of the shipbuilding industry. It should also support firms in reorganizing themselves into an industrial structure fit for future scenarios, and, after analyzing risks that may occur during the process, it should forge and manage a bond of empathy with the stakeholders. In this way, we can maintain a great shipbuilding nation, while solving the problems at hand and preparing for possible future risks.
Eunchang Lee is a senior research fellow at the Steel Research Center of the POSCO Research Institute. This was written for the East Asia Forum.