The Kaesong Closure: North-South Trade over the Longer-Run
The closure of Kaesong has led us to focus on a number of features of North Korea’s trade over the last week. We continue the discussion with an analysis of North-South trade over the longer-run, how Kaesong gradually came to dominate it and how to think about the losses the closure of Kaesong implies. There has been confusion in some recent commentary as a result of failure to distinguish between trade flows—which are large, but with low-value added in North Korea—and the transfers associated with the complex, which provide substantial foreign exchange earnings for the regime.
We started with the mystery of North Korea's missing oil imports. Chinese customs stopped reporting oil shipments in 2014. But if we impute that they have imported the same quantity of oil, but at declining world market prices, an odd outcome emerges: China’s share of North Korea’s total trade might have actually fallen last year, in part as a result of cheaper oil but in part as a result of a solid increase in the Kaesong trade. In an earlier post we took the analysis one step farther, looking at alternative imputations (with zero oil, with quantities constant, with values constant) and their influence on North Korea’s balance of payments. The headline finding: while there is some uncertainty, North Korea’s bilateral deficit with China is between $450 and $750 million. If transfer payments associated with Kaesong are about $130 million a year, that is not a trivial share of the foreign exchange required to finance of that deficit (between 17 and 29 percent).
Put differently, a number of analysts have been comparing the $130 million in transfers to North Korea's total trade of about $9.5 billion and concluded it is small potatoes. But this compares apples and oranges; losing Kaesong in fact implies a large adjustment if seen as a share of its bilateral deficit with China, and may well constitute the bulk of domestic value-added in exports outside the natural resource sector.
On the North-South trade balances, first figure below shows South Korean exports to North Korea, broken down into three different categories: the non-commercial trade (mostly food and fertilizer during the high engagement period); the “economic cooperation” trade associated mostly with Kaesong and to a lesser extent Kumgang and a few other projects; and the processing-on-commission and general trade, which can be considered more purely commercial. The second figure shows South Korean imports under each of these lines and the final the bilateral surplus or deficit on each component.
The first thing to note in the first two figures is that the non-commercial trade falls sharply with the start of the Lee Myung Bak government. With the sinking of the Cheonan and imposition of wider sanctions, the commercial and non-commercial trade fall to virtually nothing. All that is left is Kaesong.
Another way of viewing this shift is by looking at the deficits and surpluses on different accounts over time. During the sunshine era, North Korea ran large deficits on the unrequited non-commercial line (nominally financed by loans to North Korea, but obviously never repaid) and on the economic cooperation account. Interestingly, North Korean ran large surpluses on the processing-on-commission and general trade before it collapsed following the sinking of the Cheonan. The economic cooperation trade turns positive as Kaesong comes on line and ends up accounting for the small trade surplus North Korea had with the South from 2011-2015.
How do we think of the size of what might be called the Kaesong surplus? Many North Korean exports have a low domestic content share. while North Korea's exports from Kaesong are large, so are imports into the complex; despite the substantial volume of the two-way trade—over $2.6 billion—there is only a small North Korean surplus on the “Kaesong account,” and this surplus accrues largely to the South Korean firms in the zone. This is typical of any export-processing zone. All the inputs into the products exported from Kaesong—with the exception of labor—are imported from the South. Put differently, value-added in Kaesong is low. The same holds for the growing processing on commission trade with China involving t-shirts and other garments: North Korean value-added is low. The trade in mining products is an exception since both the raw materials and labor are North Korean. The fact is we just don't know if $130 million is a large or small share of domestic content in North Korean exports. It may be a small share overall, but a very large share of domestic content if the mining sector is excluded.
Although South Korea counts for a large share of North Korea’s total trade, the return from that trade is split between the companies, the North Korean government and the workers of Kaesong. What is the regime’s take? Estimates at total transfer payments are about $130 million a year, which consists of three items: wages to workers, taxes and land use fees. Taxes and land use fees are pure income for the regime. Wages are more complicated, because there is a real resource cost to the North Korean government, which must pay the workers albeit in North Korean won. But those payments are made not at the black market rate—8200 won to the dollar according to the trusty DailNK—but at the official rate which is about 125 won per dollar. (William Brown has more on this in a 38 North article released yesterday.)
Thus while $130 million needs to be seen as the upper bound of what North Korea earns from Kaesong, it is on the wage payments, roughly $100 million, that North Korea makes a killing, taking in the vast majority of its total earnings. Minister of Unification Hong Yong-pyo has come under intense pressure to resign after claiming—then retracting—that 70% of Kaesong payments went directly into the nuclear and missile program. But this estimate seems roughly correct with respect to the share of fungible foreign exchange going to the regime. DailyNK even has a feature on the precise channels through which this money moves, with the Central Special Development Guidance Bureau essentially remitting the foreign exchange directly to Pyongyang and the Central Bank providing the domestic currency for paying the workers.
The bottom line: the damage from the closing of Kaesong does not come from the loss in total trade. Instead the loss should be seen through two measures: North Korea foregoes $130 million in foreign exchange, which could be used to finance its deficit with China and other partners. And it loses some unknown share of domestic trade content, which after all, is what really matters to the North Korean economy. And it will need to figure out some way to redeploy a lot of workers from Kaesong; that will be interesting to watch.