By: Eunchang Lee, East Asia Foundation

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.

Diverse Issues

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.