Seoul tightens up after conglomerate's failure.

The collapse of South Korea's seventh-largest conglomerate has raised an intense debate over the nation's sprawling family-run business groups. Such groups have come to dominate the economy since the 1970s, when the government began to funnel cheap bank financing to a small number of large companies. The result was a decade of stunning economic expansion -- private-sector growth under the prod of the government.

But government economists now say the conglomerates have become safe harbors for inefficiency and that their owners are more interested in expansion and domination than in consolidation and profit.

As part of the new get-tough attitude toward the conglomerates, Korean banks in late February began to dismantle the Kukje-ICC group, which had assets estimated at $2 billion at the end of 1984.

The move sent shock waves through the domestic economy. It also raised serious concern among foreign bankers, who have loaned hundreds of millions of dollars to the company. The Korea First Bank, Kukje's prime bank, has put those fears largely to rest by guaranteeing all foreign bank loans to the company.

But the breakup of the group has highlighted once again the severe difficulties that Korea faces as it moves from a high-growth, high-debt economy led by a strong government development strategy to a more financially sound and efficient market system.

Like other Korean business groups, Kukje managed a dizzy array of companies -- in footwear, steel, construction, securities, machinery, paper, tires, computers, and kitchen equipment -- all on a very weak capital base.

The group was hit hard last year by the decline in overseas construction business from the Middle East at a time it was aggressively expanding at home.

The group's difficulties became severe in December, when the government authorized emergency funding and bank guarantees. That kept the group afloat until the end of February (conveniently avoiding any embarrassment before National Assembly elections). But then the banks lowered the boom, taking over the management and dismantling the group.

In business circles the fate of Kukje is a strong warning to other conglomerates to concentrate on their main lines of business and reduce their debts or face similar consequences.

All of the business groups exist to some extent at the mercy of their banks -- with high levels of debt and occasional severe cash-flow problems. But the debts are large enough to put the banks themselves into trouble. Banks have tied up increasing amounts of their assets in loans to the conglomerates. Many of the loans are nonperform-ing -- that is, the banks are not getting payments.

The interdependence goes further. Many of the banks' major shareholders are the conglomerates to which they have loaned so much money.

Foreign bankers say the amount of nonperforming loans on the books of Korean banks would be alarming by Western standards, although it is difficult to calculate since many companies are more or less automatically extended fresh loans to repay old ones, or loan agreements are renegotiated.

In 1984, loans extended by the Bank of Korea, Korea's central bank, to other banking institutions increased by 35.7 percent to a record of $8.3 billion. Much of the increase is believed to be accounted for by loans to shore up ailing businesses, including construction and shipping companies.

Foreign banks continue lending to such highly leveraged companies because they believe -- as the Kukje case bears out -- they will be bailed out in case of trouble. ``If we lend to any of the top 10 groups, we assume we are lending to Korea,'' says a banker.

``Given the amount of lending, the level of sophistication of corporate financial analysis is very low,'' he added. ``If the foreign banks had been made to take losses on Kukje, the banks would have had to change the whole method of operating and many companies' access to credit would be shut off.''

Government economists say that healthy parts of the huge conglomerates are subsidizing their inefficient wings, weakening efforts to develop promising areas of industry.

A banker cites the example of a fast-growing electronics company that is helping to keep afloat a money-losing machinery subsidiary in the same group.

More than anything, the Kukje debacle illustrates the severe obstacles that remain before the economy and the financial system can be significantly liberalized, as the government intends. That won't happen until the big business groups grow out from under the wings of their banks and until banks clear their books of bad loans. Says a foreign banker, ``They have to get rid of the debt on both sides before the economy can become market driven.''