Korean Shipbuilding: Running on a Treadmill?

Shipbuilding in South Korea is one of the country's leading export industries. The country leads the world both in terms of production by tonnage and technologies of large-scale vessel and maritime equipment. Currently, however, the Korean shipbuilding industry faces a range of challenges, both inside and outside the country. It must wage competitive battles with China and speed up the pace of technological change in order to maintain current levels of revenue.

Shipbuilding in South Korea is one of the country's leading export industries. The country leads the world both in terms of production by tonnage and technologies of large-scale vessel and maritime equipment. These achievements have been the result of effective industrial policies pursued consistently over the past 30-40 years by the government and top business groups in Korea. Currently, however, the Korean shipbuilding industry faces a range of challenges, both inside and outside the country. It must wage competitive battles with China and speed up the pace of technological change in order to maintain current levels of revenue.

How to Become a “Global Shipyard”

South Korea's record is particularly illustrative, since only forty years ago the country had no advanced shipbuilding capabilities. And yet, by the turn of the century, Korea has become the world's leader in shipbuilding.

Korea was successful in adopting the "flying geese" pattern, which in the 1980s was used to describe booming growth in the "emerging industrial countries" which structured their value-added chains around dominant technologies in the market. Industrial growth in these countries (first in South Korea, and then followed by the rest South-East Asia) was driven by Japanese corporations responsible for exporting capital and technology and moving their production to countries with cheaper labour.

South Korea painstakingly followed a route which took it from assembling simple vessels from imported spare parts in the 1970s, to more localised production of machines and equipment in the 1980s, and to then to its status as a global shipyard by the late 1990s.

Apart from benefiting from state industrial policies, South Korea's competitive advantage came from the monopolisation of the sector by integrated business groups (chaebols), with administrative leverage and financial capacities to invest unimpeded in large-scale development projects consistent with government strategies.

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A ship under construction in Guangzhou

In the 2000s, South Korea's position on the market underwent a significant test: China decided to try its hand at shipbuilding. Over this decade, it increased its share in new tonnage built from 4.7 per cent to 38.3 per cent.

Although we have not yet come to the point where this country has forfeited its technological leadership, the trend is disquieting. The main reason for this development is that China is currently playing the same trump cards that once allowed South Korea to gain its global leadership in shipbuilding, i.e. low costs and a sound organisation of production.

Competition is being aggravated by developments in the shipbuilding market. In the mid-2000s, there was an explosion in the number of new orders placed. While in the 1990s, the order book relative to total deadweight in operation did not exceed 15 per cent (with an historical value of 10 per cent), during the shipbuilding boom in 2007-2008, this ratio jumped to 49 per cent. However, the pace at which old tonnage was recycled grew almost 9 times between 2005 and 2010.

By 2009, the market was so saturated that new orders placed for merchant ships accounted for a meagre 8 per cent of 2007 record highs. At the same time, the world economic crisis hit the freight market and left substantial surplus tonnage uninvolved in the then current traffic flows.

As a result of aggressive investment channelled in the 2000s towards production expansion, the future demand by international fleet for new tonnage even by 2020 will hardly reach 80 per cent utilisation of current capacity.

The current trends underpinning the growing competition between South Korea and China have led to a drop in shipbuilding prices. In 2011 alone, prices across various segments of the merchant fleet dropped by between 5 and 15 per cent. In 2012, the average decline was in excess of 8 per cent. In 2011, prices for some items were slashed 50 per cent from their peak values in the early 2008.

Significantly, by the late 2000s, the shipbuilding sector had to introduce a series of new safety and environmental standards, which could not but result in higher costs (because of the labour involved and the materials and technologies used), even for standard vessel designs that were now subject to new rules.

All this, together with the shrinking down payments due for new orders after 2009, meant that South Korean shipbuilders were facing tougher financing terms and conditions. This led to higher leverage (in 2012, alone they raised a record US$ 2.7 billion of debt) and attempts to generate liquidity by selling off some of their assets. Chinese shipbuilders, in turn, responded with a greater focus on the domestic market (China’s 27.1 per cent against merely 7 per cent in South Korea), and benefited largely from their government’s propping up of sales.

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Aegis ship, South Korea

Along with growing energy prices and salary costs, between 2002 and 2008, the four leading South Korean shipbuilders (Samsung Heavy Industries, Hyundai Heavy Industries, DSME and STX) saw their labour costs rise by nearly 1.5 times, largely due to growing order books. With well-organised and established trade unions, wages cannot be cut drastically unless you want serious labour conflicts. Thus it became one of the competitive edges lost, compared to the 1970s and 1980s, at the time of quasi-authoritarian regimes of the Fourth and Fifth Republics, when Korean trade unions were largely oppressed with few opportunities to demand higher wages.

However, despite the obvious trend towards higher costs, Chinese labour remains so much cheaper that in 2010, in similar shipbuilding projects, Koreans spent 45 per cent more than their Chinese counterparts (adjusted by labour productivity).

It is exactly this factor that is believed to be key to the Korean choice of strategy. Already in the mid-2000s, South Korean corporations started withdrawing from the “Chinese-dominated” parts of the market and concentrating on market segments of larger and technologically more sophisticated, higher value-added vessels that China is yet to learn to produce properly.

In the early 2000s, bulk carriers, for instance, so much favored by Chinese shipyards, achieved $290 of added value per compensated gross ton, in contrast to Korean shipbuilders’ specialty products, which realized about $500 of added value for a large container ship and $680 for an LNG carrier.

Take, for instance, South Korea’s focus on its offshore range of products: jack-up rigs and stationary rigs, and auxiliary oil and gas ships. By the end of the 2000s, Korea’s four largest shipbuilders had from 26 per cent (Hyundai Heavy Industries) to 51 per cent (Samsung Heavy Industries) of the portfolio, by value, concentrated in rigs and drilling ships. By tonnage, these units accounted for less than 8-10 per cent of their total portfolio.

Revolution Looming

Hence, South Korea has opted for a strategy of intensified technological progress and speedy innovation in its shipbuilding. Statements to this effect can be easily found in almost any report or presentation by Korean shipbuilders. Their key risks relate to the skill-driven economy or, rather, to the projection of growth rates against those of their key competitors, whom they plan to outperform in high value-added segments.

This will require a continuous transfer of foreign technologies as well as a boost to domestic R&D. With this particular focus on offshore units, where many key technologies still have to be imported, the work to be done is all about production, with Korean corporations contributing little to the design and development of these units.

South Korea has seen mixed results with regards to its progress towards a knowledge-based economy. On the one hand, over the past decade it has consistently come in third in terms of R&D spending as percentage of GDP (or fifth, in terms of total R&D spending), outstripping such established technological leaders as the US or Germany, or firmly staying on par with them in terms of the number of R&D researchers per capita (http://www.unescap.org/stat/data/syb2011/I-People/Research-and-development.asp). These indicators are a reflection of government policies as well as that of the leading business groups aimed at more intensive R&D.

On the other hand, it will be no exaggeration to state that the limited scope of R&D incentives is one of the recognized obvious challenges that South Korea’s research sector faces. However, the efficiency of these incentives has so far been rather low, judging by such indicators as the number of academic publications or patent applications.

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South Korea’s share of the world’s academic publications in applied and engineering sciences (pertinent in the context of plans for shipbuilding and associated fields) is just 2.8 per cent, putting the country in tenth place. This share has been growing slowly, but it has yet to reflect the magnitude of investments made. As for patent applications, despite aggressive investment in R&D, the number of applications in South Korea has changed little over recent years, compared to almost doubling growth in China, which overtook Korea in this indicator in 2010, or Japan or the US, who still reign supreme.

This illustrates the trap that Korean shipbuilders might end up in should the commercial shipbuilding market become oversupplied.

Squeezed by China out of its traditional market positions, South Korean shipbuilding may start having issues if it focuses on high value-added projects and specialty marine equipment. Importing technologies that they lack, something that traditionally they have relied on to boost growth, first, has limited potential, and, secondly, is an equally available strategy to Chinese shipbuilding. Developing their own industrial know-how may fail to have the required effect on Korean R&D and run into a shortage of skilled labour. At the same time, the traditional bread-winners in the industry, the established merchant fleet designs, have been gradually taken over by Chinese competition, eroding revenues so desperately needed at the time of restructuring.

Essentially, shipbuilding in South Korea is facing the need to perform yet another leap. The flying geese paradigm that was used to pull the country up at the time of “new industrialization”, now that there is no outstripping growth in the research sector, has already been hitting the country’s competitive advantages, forcing it to leave lower-value-added markets to Asian players that are dogging Japan and Korea.

Given the close price competition, a way out can be either to radically reduce the output in the industry and shift investments to other engineering sectors, but this might undermine growth in the economy and push up unemployment (since shipbuilding today accounts for up to 8 per cent of Korea’s total exports, with a record high of 12 per cent, compared to the early 2000s, when the value was firmly below 6.5 per cent), or else hope for a radical breakthrough in innovation capable of generating, on a sustainable basis, more engineering advancements.

In other words, South Korea must follow Japan’s route, and not only in shipbuilding. There is an important role for China here as it presently has a number of joint ventures in shipbuilding, established on a parity basis with Daewoo Shipbuilding and Samsung Heavy Industries.

So, while the first revolution in South Korea was industrial and helped create a large-scale and well-structured production sphere based on mass imports and foreign technological solutions, the second revolution should help the country set up its own fundamental and applied research capacity fully capable of securing Korean shipbuilding corporations long-term, sustainable leadership.