Merchant ships are capital goods with some distinctive features that make it difficult for outsiders to analyse their true building costs. A precise calculation very much depends on information about the particular building project and the yard facilities used, both of which are normally kept confidential.

These characteristics lead to a great number of variables that need to be factored in when analysing the true production costs for individual vessels and prove (or disprove) allegations of unfair pricing.

In order to collect the necessary data, the European Commission has recourse to independent, reliable consultants. Their ongoing study covers the following elements:

The study covers shipyards in Korea, Japan, China and Singapore and a range of shiptypes (>5000 gross tonnes), mainly: crude oil tankers, bulk and OBO carriers, product and chemical carriers, general cargo ships and reefers, containerships, RO-RO vessels, gas carriers, passenger ships and off shore vessels. A total of 33 ships contracts are to be analysed within the study.

Orders for new ships are selected for analysis in co-operation with the European shipbuilding industry to ensure that technical data from comparable projects is available and technical and economic assumptions can be kept to a minimum. Given the critical nature of such an investigation, parameters are to be kept on the "safe side" to assure that calculated minimum costs for particular projects cannot be challenged.

To date nine orders for new ships have been analysed, all awarded to South Korean yards. The European Commission assured a balanced selection of cases while taking into account the overall political objective of the exercise, the relative urgency of the matter and the availability of meaningful data for comparison. Investigations may be extended to shipyards in other Asian countries in the course of the study if necessary. The cases covered so far are:

Not all of the selected projects are confirmed orders and in some cases the financing is not yet in place, which could lead to higher or lower order prices, depending on the particular situation. The European Commission is, however, convinced that the information entered into the analysis is at present the best available and that the selected shipbuilding projects give a fair illustration of the abnormal financial conditions at which orders have recently been taken by Korean yards. As the cost model is constantly refined and previous analyses are updated accordingly, a final assessment can only be provided in a later report. However, as mentioned above, all parameters are set conservatively and changes should only occur in the direction of even greater differences between order price and normal building price.

Another factor of uncertainty is the actual order price. Different sources often quote different prices and for larger series the individual order price might be lower because of (real or perceived) economies of scale. In this context it also needs to be mentioned that the model tries to reflect the actual behaviour of Asian competitors, e.g. costs for currency hedging are not factored in for Korean shipyards as it is known that these precautions typically are not taken.

The following tables summarises the findings so far:

At first sight the results presented in Table 3 seem to indicate that all orders investigated are loss making. However, it may be considered as acceptable business practice that a yard renounces any profit for a specific contract or accept to build a ship at a small loss if this allows it to make a strategic foray into a new market segment, provided that this does not become a permanent policy and that the loss from one contract is covered through other profitable contracts. Under these circumstances, and allowing a certain error margin for the cost model, a reported contract price of up to 10-13% lower than the calculated "normal price" could be considered as acceptable. Consequently one of the investigated orders (the product carrier from Daedong) can be seen as in line with normal business practice. The remaining eight orders are, however, clearly loss-making, with losses between 15 and 40% of the calculated normal building price. Since Halla and Daedong are technically bankrupt and have been operating under court receivership since December 1997 and February 1997 respectively, further investigation is needed to find out why such orders are accepted and how the loss is accounted for. The cases of Halla, Daedong and Daewoo are discussed later in the report in Annex II.

There are indications that Korean yards fix vessel prices according to the level the shipyard perceives the market will bear, rather than through a bottom-up estimate, and production and purchasing targets are set accordingly. Reports indicate that Korean yards work backwards from the ship price to allocate the value to each item of supply. Often initial bid prices by suppliers are ignored by Korean shipyards and a target price is given. This policy is acceded to by Korean equipment suppliers, irrespective of the effect it may have on their own business. One European equipment manufacturer questioned has undertaken significant research into his competitors in Korea. He found that his biggest competitor published a loss of about 30% of turnover and that other Korean manufacturers were facing similar problems. As equipment suppliers in South Korea are often part of the same larger conglomerates, the so-called chaebols, as the shipyards, true costs for particular operations are difficult to establish.

A negative impact on EU yards is assumed when the order is made at a price which does not cover costs and which is low enough to keep the order out of reach of EU yards. This is particularly true if the owner has traditionally placed orders with EU yards. However, even where Asian competitors had significant market shares in the past (e.g. for container ships or bulk carriers) the depressive nature of this pricing policy will have a negative effect on the market in general and, on this basis, the price may be perceived to be injurious. Whilst this contract may not take work directly from an EU builder there will be a "trickle down" effect in the market as a whole, which will have a detrimental effect on shipbuilding in the EU.

All of the 9 orders investigated had an impact on EU yards. The key elements for the investigated cases are as follows:

The conditions under which shipyards such as Halla or Daedong operate (for more details see also Annex II) merit a closer look to the South Korean banking system in general and to the way in which export and operational credits are awarded.

The Korea Export/Import Insurance Corporation (KEIC) was established by the Government of South Korea with the express purpose of guaranteeing risks related to exports borne by all Korean companies.

This role has been revised and KEIC now guarantees that buyers receive their advance payments back in case a company (in this case a shipyard) goes bankrupt and the bank that has given the refund guarantee also fails to cover the payment. This basically means that buyers of Korean-produced tonnage have their payments guaranteed by the Korean State.

The Export Import Bank of Korea (KEXIM) which is fully owned by the South Korean Government provides instruments to exporters to boost South Korea's exports of capital goods such as ships. Two subject matters are of relevance here: The "export financing facility" hands out loans to shipbuilders during their production period, before the delivery of the ship. The "refund guarantee facility" guarantees the refund of down-payments when shipbuilding contracts are not fulfilled.

Under western European markets conditions these facilities could be established with interest at LIBOR+ 2 to 3 percent, depending on the shipyard's creditworthiness. KEXIM provides the "export financing facility" with interest rate at LIBOR plus mark-up 2.66% plus risk premium starting at 0.25%depending on the shipyard's creditworthiness and collateral, and the "refund guarantee facility" with guarantee commissions starting at 0.4%, according to creditworthiness. Given the high indebtedness of the South Korean yards it is clear that the rates offered by the KEXIM bank do not cover the risk related to these facilities. For some Halla contracts the costs of KEXIM guarantees are reported to be 1% of the contract price because of the precarious situation of this yard. This is considered very low.

As 92% of the total guarantees provided by KEXIM were for shipyards in the period of January to November 1998 the provision of export guarantees by KEXIM can, at least for this period, be considered a sector specific operation. Moreover, the fact that the bank is state owned and that the state has covered its losses by means of capital injections can be assimilated to a sector specific state aid case.

KEXIM has also taken over refund guarantees from weaker commercial banks. This additional risk is balanced through KEIC in case of failure. As a result, buyers of Korean-produced tonnage can rely on risk coverage through the Korean government, even if non-KEXIM guarantees are used.

Korea Exchange Bank, the main creditor of Halla, is owned by the Bank of Korea (32.1%), Commerzbank AG (Germany's third largest bank, 30.4%) and private investors (37.5%). Korea Exchange Bank has received fresh capital from various investors, including Commerzbank AG and KEXIM. In addition the state-owned Bank of Korea has made a direct investment of 700 Billion Won in KEXIM, to allow it continuing the provision of financial support to exporters and to raise its capital adequacy ratio. KEXIM in turn invested in the Korea Exchange Bank (thus helping, at least indirectly, Halla). Other Halla creditors are SeoulBank, Industrial Bank of Korea and the Foreign Exchange Bank of Korea, all of which are at least partially under public interest. SeoulBank, which was until recently 95% state-owned, has been declared a non-viable lender by the Financial Supervisory Commission and is now entirely under state control. Its bad loans have been transferred to Korea Asset Management Corporation, a state agency, and it remains to be seen if the credits to Halla will be treated according to standard commercial terms.

This closely knit network of financial institutions and the continued government influence in the banking sector provides the ground for a possible non-market-oriented behaviour of the creditors vis a vis the shipbuilding industry. Following a Council request the previous Commissioner for Industrial Affairs Martin Bangemann visited South Korea in May 1999 to discuss the issue with the Korean Government and the shipbuilding industry. In response to the Commissioner's oral and written inquiries, notably in relation to the possible use of IMF Funds, the South Korean Government replied that such funds are only used to bolster currency reserves and noted that they do not follow up on the use of funds once they have been disbursed to commercial banks, even if these commercial banks are under public control.

Given the particular nature of shipbuilding contracts, and the paramount importance of financing schemes, it seems crucial to gain more insight into the issue of the financial funding of South Korean shipyards.