If the signals emerging from the South Korean film world these days seem a bit contradictory, it may be because the industry is on the brink of a transformation.

Despite producing numerous award-winning films and an amazing 47% local market share in 2002, Korean cinema finds itself facing a host of challenges, many of which may have been triggered by its own success. The coming year is likely to see major changes, if not a complete re-modelling of the industry.

The major source of the upheaval was a sudden exodus of investment funds at the end of last year. The industry's boom years date from 1999, when venture capital moved into the film sector, filling the space left when large conglomerates such as Samsung and Daewoo ceased their film operations.

What started as a steady flow of investment increased to a torrent in 2000-2001 with the success of films like Joint Security Area ($31m local gross) and Friend ($44m). Outside investors, dissatisfied with meagre earnings from the stock market, poured money into film in anticipation of double-digit returns, often with little knowledge of the industry and no consideration of a project's risks.

Those two years in which money seemed to fall from the sky have changed the industry. Production costs have more than doubled, while average p&a spending has almost quadrupled since 1998. Production levels increased from 43 films in 1998 to 77 last year, providing for increased competition among local films.

Labour costs for both cast and crew have shot up, and talent management companies such as Sidus HQ have started demanding significant percentages of a film's gross in return for the casting of a major star.

Finances have been further squeezed by local practices in which investors shoulder all the risk of a project, but divide profits 50:50 or 60:40 with the film's production company.

Although 25 of the Korean films released in 2002 grossed more than $3m at the local box-office, inefficient planning meant that investors were still losing money.

For projects that failed, such as the infamous big-budget trio of Yesterday, R U Ready' and Resurrection Of The Little Match Girl from mid-2002, the losses were staggering.

By the end of last year, it became apparent that the majority of venture capitalists were looking for an exit. "Although a lot of film investment funds still have a year or two left before they expire, the fund managers have stopped investing in new films," says Hwang Dong-mee of the Korean Film Commission's Research and Development Department. "They've seen too many failures. "

As the investment bubble burst, films like Mr. Lady and Deus Machina ground to a halt in mid-shoot. "The party's over," declared producer Tcha Seung-jai of the industry's boom at the Pusan International Film Festival in November. "The only thing left is to figure out who will wash the dishes."

Yet a glance through the industry reveals that production houses are facing widely different circumstances. Companies that have allied themselves to well-funded major distributors, such as Taewon Entertainment and Fun & Happiness with Cinema Service, or Myung Films with CJ Entertainment, may find little changed apart from a new note of fiscal caution. Shortly after it became apparent that venture capitalists were pulling out, Cinema Service announced that it was stepping up its investment to 20 local features a year.

Then a major twist developed in January, when news surfaced that Cinema Service and CJ Entertainment were negotiating a merger. As the two biggest companies in the film industry by far, a merged entity would tower over all others in the investment, production, distribution, and exhibition sectors. Smaller companies viewed the developments with panic.

With a return of venture capital unlikely at best, mid-sized and smaller companies will have to look to other sources to finance their films. Ancillary markets in Korea remain quite small compared to other countries, and although television companies such as MBC have invested in a few local features, their contribution is likely to remain minimal. Similarly, revenues from video and DVD remain a fraction of that in other territories.

It is likely that production companies will have to start looking abroad for investment help, and one potential source looks like being the Hollywood studios. Apart from remake rights, which have provided the industry with an unexpected and potentially lucrative source of income, two studios have committed to direct investment in Korean films.

Buena Vista made a killing on its first-ever Korean venture The Phone, which cost $2.5m to make but which grossed $11m at the Korean box-office last summer. BVI is also planning to release the film in Japan, where test audiences have shown strong interest. Columbia Tri-Star has also committed to fully fund Kang Woo-suk's Silmi Island, a big-budget film based on an assassination attempt on South Korean president Park Chung-hee in the 1970s. However, at this point nothing suggests that involvement by the Hollywood majors will amount to much more than an occasional project.

With limited options available to them, 2003 may be the year when Korean companies start looking seriously at international co-productions. Korea has yet to sign any co-production treaties, however the Korean Film Commission is planning to open negotiations with several countries over the coming year.

Most local companies seem eager to pursue co-productions in theory, but have yet to forge the contacts and expertise to do so. With a strong local market, significant inroads made into other Asian territories and a burgeoning international profile, Korean films may offer overseas investors an intriguing prospect.