Between Collapse And Revival: A Reinterpretation of the North Korean Economy
Paper to be presented at a conference on Economic Development in North Korea and Global Partnership
Cheju, South Korea
© Peterson Institute for International Economics
I would like to thank seminar participants at the Council on Foreign Relations for helpful comments on an earlier draft. Derek Bruzewicz provided useful research assistance.
Coping With the Present
Considerable uncertainty surrounds the state of the North Korean economy. There is universal agreement that North Korea has experienced a decline in output since the collapse of the Soviet Union and the break-up of the Eastern Bloc, though precise estimates vary enormously.1 There is also agreement that North Korea has experienced a famine, though disagreement remains as to the timing of the famine and its associated death toll.2 There is little agreement as to the current state of the North Korean economy.
The most widely cited figures in public discussions are those produced by the South Korean central bank (Bank of Korea). (The Bank of Korea [BOK] is given this task because it would be responsible for monetary policy in a Korea united under Seoul.) The annual BOK estimate of North Korean national income is constructed by applying South Korean value-added weights to physical estimates of North Korean output obtained through classified methods. Ergo, this estimate may differ significantly from the true underlying figure due to the inadequacy of the calculation method, and in any event, it is not subject to any verification by outside analysts. The BOK figure is then subject to interagency discussion. Once a consensus is reached, the BOK figure is transmitted to the Ministry of National Unification, which announces it to the public.
Normally, this figure is released in the spring. In the spring of 2000, however, the Ministry of National Unification did not release a specific figure, instead adopting the formulation that North Korean national income was approximately unchanged in the previous year. Then in June, just prior to the North-South summit, figures were released indicating that the North Korean economy had grown by 6.2 percent in 1999 (Table 1). The BOK announcement was greeted with considerable skepticism by both economists working outside the South Korean government and foreign officials based in Pyongyang.3
There are at least five possible explanations for the divergence between the expectations of professional observers and the BOK's numbers. The first two possible explanations relate to the role of foreign aid. As shown in Noland (2001), North Korea is an increasingly aid-dependent economy. In recent years, aid inflows have amounted to approximately two-thirds of recorded merchandise exports, and aid together with revenue from illicit activities such as the exportation of missiles, drug and endangered species trafficking, and counterfeiting, have roughly equaled the total value of exports.
The first explanation, which was plausible before the release of the BOK's sectoral data in June, related to the domestic availability of food. Numerous observers reported increased food availability in North Korea in 1999, due to large-scale international assistance and an improved domestic harvest made possible by international donations of fertilizer and other inputs and better weather. In technical terms, food aid would contribute to increased consumption or availability of food, but would not contribute to domestic value-added and hence national income. (The fertilizer and improved weather could contribute to increased yields, and this could add to national income properly measured.) The explanation for no change in output in 1999 (which could be interpreted as a bottoming out of the decline) could therefore be rationalized as a misinterpretation of increased food availability together with legitimately improved circumstances in the agricultural sector.4 The problem, of course, is that the figures in Table 1 show increased output not only in agriculture, but throughout the economy. A more sophisticated version of this argument would be that international assistance acts as implicit balance of payments support, permitting the importation of non-food items with the hard currency that would have otherwise been used to purchase food, and that observers have confused the increased availability of various products (made possible by aid) for increased domestic production.
The second possible explanation is a variant on this argument. International assistance acts as implicit balance of payments support and the North Koreans have very wisely spent their implicit windfall on critical imported intermediate inputs that have allowed them to increase capacity utilization. The issue then becomes whether this is self-sustaining - that is, if aid were cut off, would the apparent recovery of 1999 collapse?
A third explanation revolves around the reputed existence of a classified North Korean input-output table constructed by economists at the BOK. The secret input-output table presumably embodies a different set of input-output weights than the South Korean input-output table. Hence, if one took the same physical output data and aggregated it using the different value-added weights, one would obtain differing estimates for national income. Thus the reported jump in North Korean output could simply be a statistical artifact produced by concatenating two series produced using two different sets of value-added weights. If this were the case, then one would expect to observe a one-time discontinuous movement in the series. Put differently, if this explanation is correct, then ceteris paribus one would expect that next year's growth figure would fall within the range of figures prior to 1999. While this explanation has a certain ring of plausibility to it, economists at the BOK steadfastly deny that this is the case.
The fourth and fifth explanations are the most straightforward: everyone outside the BOK just got it wrong, and/or the BOK figure has been fabricated. Neither explanation is entirely implausible. Even specialists on the North Korean economy have remarkably little access to conventional economic data, and it could well be the case that the community of North Korea-watchers simply has gotten it wrong, and that the North Korean economy is doing far better than expected.
Alternatively, the state of the North Korean economy has become a highly sensitive political issue in Seoul, and as Eberstadt (1995) reminds us, South Korean government statistics are not always above reproach.
Even the more narrow issue of food availability remains subject to dispute. The conventional wisdom is that the country suffered perhaps 2 million excess deaths due to a famine that peaked in 1995-97, though due to lack of access, this figure is little more than a guesstimate.5 By 1999, the North Koreans were signaling that enhancing supplies of energy, not food, was their top priority, and the Rodong Sinmun's 2001 New Year's editorial identified the power industry as "the most important front for socialist economic construction."
Nevertheless, during the summer of 2000, official relief agencies were once again claiming that the situation in North Korea was deteriorating, and the North Koreans requested through the World Food Program (WFP) $250 million in aid, which it was asserted would permit them to attain minimum human needs self-sufficiency by 2002. Both the Food and Agriculture Organization (FAO) and the South Korean Rural Development Administration eventually concluded that domestic production had fallen by approximately 15 percent from the previous year, making the 1999/2000 growing season the worst since 1996/1997.
The situation in 2000 differed from that in the mid-1990s in three principal ways, however. First, even the relief agencies accepted that the long-run solution to North Korea's food problem would require strengthened trade performance, to both facilitate the importation of inputs such as fertilizers and pesticides, and allow the North Koreans to cover unexpected shortfalls on commercial terms.6 Second, frustrated by lack of access and North Korean dissembling, a number of non-governmental organizations, including Médecìns Sans Frontières (Doctors Without Borders), World Concern, Oxfam International, Action Against Hunger (ACF), and CARE, have left North Korea. Third, while the US government used the WFP humanitarian appeals as diplomatic cover for its political deals with the North Korean government, this fig leaf has grown increasingly worn. Of course, the puzzle remains, if the North Korean economy experienced sustainable industrial growth of more than 6 percent during the past two years, why would they need $250 million in grant assistance?
Whither North Korea?
In the face of its decade-long calamity, North Korea has pursued two coping mechanisms: one-off projects to generate foreign exchange and extortion. In the former category one could count the Rajin-Sonbong special economic zone and the Mt. Kumgang tourism project. The Rajin-Sonbong initiative has been a major disappointment, and the second venture is not without problems, either. In an October 1998 agreement, Hyundai guaranteed North Korea $942 million over 75 months, with the payment schedule front-loaded for the first six months. At $300 per passenger, North Korea could make $450 million a year in the unlikely event that Hyundai was able to meet its targets and fill all the berths on its ships. To put this in perspective, this money, if properly deployed, would be enough to cover the North Korean grain deficit on commercial terms. However, Hyundai has had difficulty filling its ships, and through the end of 2000, it has reportedly lost nearly $400 million on the venture, contributing to the financial distress of the group. Indeed, it is rumored that Hyundai missed at least one of the monthly payments, and it reportedly attempting to renegotiate its contract with the North Koreans.7
The second coping strategy is extortion, and North Korea has experienced some success in extracting resources from the international community through brinkmanship. Numerous times the US government, for example, has provided North Korea with food aid to induce its participation in various diplomatic forums (Noland, 2000, Table 5.3). Indeed, some would argue that North Korea has shown considerable diplomatic acumen in parlaying uncertainty about its nuclear program into a multi-billion dollar energy assistance program. Since 1994 the share of North Korean food imports obtained on concessional terms has risen from nil to more than 80 percent.
Yet North Korea appears to be winning the battles but losing the war. Its essentially opportunistic behavior does indeed allow it to extract resources from the rest of the world, but in the absence of more fundamental reforms, these resources are insufficient to revitalize the economy.
Indeed, events of the past year suggest that North Korea is moving beyond these narrow coping mechanisms. For the past decade the North Koreans in general (and specifically in writings or statements attributed to Kim Jong-il) have been absolutely scathing in their denunciations of the reforms undertaken in Eastern Europe and the former Soviet Union. Foreign influences have been likened to "germs," "mosquitoes," and other vermin to be kept at bay. "Reform" has been described as "honey-coated poison" and "opening" as "a Trojan horse tasked with destabilizing socialism," and in 1994, the North Koreans went so far as to call the Chinese "traitors to the socialist cause" until their own worsening situation and growing dependence on China made it prudent to tone down the rhetoric.8
The language used during Kim Jong-il's May 2000 pre-summit visit to Beijing was very different, however. In remarks widely broadcast in China and reported in the international press, Kim noted the "great achievements of opening up the country" by Chinese reformer Deng Xiao-peng and announced that North Korea "supports the reform policy pursued by the Chinese side." These comments suggest a new receptiveness to economic reform on the part of the North Koreans, and open up the possibility of Chinese adopting their natural role as mentors in this regard. In a similar vein, during US Secretary of State Madeleine Albright's October 2000 visit to Pyongyang, Kim expressed interest in the "Swedish model." During his second visit to China, he also reportedly expressed interest in the policies of Park Chung-hee. Since then, references in North Korean statements for the need for "new thinking" have begun cropping up.
This possibility received another boost with Kim Jong-il's January 2001 return trip to China, in which he visited economic venues such as the Shanghai stock exchange, a GM auto assembly factory, and a Japanese semiconductor factory. Some have interpreted these visits, in which Kim was accompanied by senior military figures, as an attempt to demonstrate to his reputedly recalcitrant military establishment the possibility of pursuing economic reform while maintaining political control and military strength.
A second signal of new thinking can be seen in the North-South dialogue. In November 2000, North and South Korea signed four treaties on economic cooperation. These treaties, establishing rules for taxation, investment guarantees, means of direct financial transactions, and settlement of trade disputes, create the legal framework for Southern investment in the North. As such, they could be quite important in terms of facilitating investment by South Korean small- and medium-sized enterprises.
A final piece of evidence can be adduced from North Korean actions. The most prominent example of North-South economic cooperation has been the contract that Hyundai signed with Pyongyang. Although the Mt. Kumgang tourism project understandably has attracted the most attention, the provision for Hyundai to construct an industrial park may have more economic significance in the long-run by encouraging investment by small- and medium-sized firms. Establishment of the industrial park has been delayed by a dispute over the proposed location. Kim Jong-il reportedly expressed a preference for Shinuiju over the Haeju district, despite the latter's greater attractiveness as an economic hub. Some (e.g. Moon, 2000) argued that the choice between Haeju and Shinuiju will signal whether economics or politics are driving policy. The announcement in August 2000 that the facility would be located at Kaesong would seem to suggest that economic rationality is beginning to assert some predominance over political symbolism.9 The North Koreans may have also begun to relax their stance with regard to Japanese tourists visiting Mt. Kumgang, which would have obvious implications for Hyundai's bottom line.10
These moves suggest a certain rethinking of North Korea's development strategy. Although these moves may seem dramatic by North Korean standards, to this date, they do not add up to much by world standards. Whether the North will move beyond these "adjustments" and attempt more far-reaching systemic reform is unclear. Nevertheless, it is worth pondering what might happen if the North continued along this path. In this regard they face significant obstacles, and have one tremendous advantage.
There is now an extensive corpus of evidence on the experiences of socialist economies making the transition from the plan to the market. What stands out is importance of idiosyncratic factors in determining relative success. To the extent that there are systematic determinants of success, the experiences of other CPEs indicate that there are three reasonably robust indicators of likely success in transition: the degree of macroeconomic stability at the time that reform is initiated, the existence of a functioning pre-socialist commercial legal system, and the existence of a large, labor-intensive agricultural sector.11
In the case of North Korea, there is some uncertainty surrounding each of these issues. Little is known about the current degree of macroeconomic stability, though the effective dollarization of the economy is not an auspicious sign in this regard. As for its pre-socialist commercial legal system, some argue that the commercial institutions of the Japanese colonial period, while not as advanced as say those in pre-socialist Czechoslovakia or Hungary, might form an acceptable foundation for the construction of market institutions. Perhaps the issue of the agricultural sector is both the most straightforward, and the source of the greatest misconception.
In Asia, one all too often hears the following syllogism. There are two ways of reforming centrally planned economies: the unsuccessful European big bang approach, and the successful Asian gradual approach. North Korea is an Asian country, ergo it will adopt the successful Asian gradual approach and begin growing 10 percent annually upon commencement of reforms. This view is mistaken, conflating the issues of speed of transition and initial conditions.
There are two large Asian countries that have experienced relatively successful transitions from central planning to the market, namely China and Vietnam. As shown in Table 2, both China and Vietnam had more than 70 percent of their labor forces in the agricultural sector when they began their reform processes, and the relative success of their reforms was strongly affected by the existence of this large pool of extremely low productivity labor in the agricultural sector. The authorities could liberalize agriculture, generating a relatively rapid supply response, and then release surplus labor from the agriculture sector into the nascent non-state owned light manufacturing sector. (In theory one could then tax the light-manufacturing sector to generate financial resources for the restructuring of the old state-owned heavy industry sector.)
This agriculture-led reform process may simply not be available to North Korea due to its very different initial conditions. Economically, North Korea more closely resembles some countries of Eastern Europe or the former Soviet Union than China or Vietnam. Vexing issues such as the restructuring of state-owned industrial enterprises, which no country has handled very well, may play a much more central role in North Korea's transition than they have in the experience of China or Vietnam.
A second obstacle is political. Again, consider the cases of Vietnam and China. In the case of Vietnam, North Vietnam and its Vietcong allies defeated South Vietnam in a civil war and unified the country. The government in Hanoi became the sole arbitrators of what it meant to be Vietnamese. When the reform policy of doi moi was undertaken in the late 1980s, the ideologues in Hanoi could come up with justifications of why the new policy was really what Uncle Ho had in mind. Similarly, while China confronts the rump of Taiwan, perhaps until the March 2000 defeat of the Kuomintang candidate for the presidency, no one seriously believed that the government in Taipei presented an ideological threat to Beijing. When Deng spearheaded the Chinese reforms in the late 1970s, the ideologues in Beijing were free to come up with slogans rationalizing the new policy.
The divided nature of the Korean peninsula presents prospective North Korean reformers with a very different ideological challenge. Reforms that bring North Korean society closer to South Korea could undermine the whole ideological justification for the regime - why be a third-rate South Korean when one can head south and become the real thing? The dynastic nature of the North Korean regime makes this political task even harder still, as the son will in effect, have to disavow the policies of the father.12
Balanced against these challenges is one great advantage with other transitional economies have not had - namely the existence of a benefactor in the form of South Korea. This could be both a blessing and a curse. While on the one hand, the South Koreans could provide the capital, technology, and access to worldwide marketing channels that the North Koreans desperately need, the easy provision of aid could actually impede reform, by lessening the incentive to change, and diverting effort into aid-seeking activities.
Globalization in Our Own Style
International cooperation could be expected to yield economic benefits to North Korea in the form of enhanced trade and investment, assistance from multilateral development banks, and settlement of post-colonial claims against Japan. At the same time, to obtain these benefits, North Korea presumably would have to forego its current revenues from exportation of medium-range missiles and weapons of mass destruction, drug trafficking, counterfeiting, and other illicit activities. Furthermore, North Korea would have to settle private claims arising from past international loan defaults were it to reenter international capital markets. Such a deal could well involve the alteration or renegotiation of the Agreed Framework upon which much of North Korea's economic interaction with the rest of the world is conditioned.
Fundamental reform of the North Korean economy would have two profound effects: first, there would be a significant increase in exposure to international trade and investment (much of this with South Korea and Japan, two countries with which North Korea maintains problematic relations), and second, changes in the composition of output could be tremendous, involving literally millions of workers changing employment.13 Both developments could be expected to have enormous political implications, or alternatively, these implications could be thought to present significant, perhaps insurmountable, obstacles to reform under the current regime.
Nevertheless, it is possible that North Korea could attempt a less ambitious reorientation of its economic policies and practices supported by help from abroad. The North Korean economy desperately needs two things to meet the minimum survival requirements of its population: food and energy. It may well be that the country obtains enough income through production or aid to attain the minimum survival basket, but chooses not to do so (i.e. the regime has a strong preference for guns over butter). Taking these preferences as given, how much additional income would the country need to hit the minimum survival basket? Under current conditions North Korea runs a structural food deficit of around two million tons. The cost of closing this gap through commercial imports would be on the order of several hundred million dollars, depending on prevailing global prices. For the last five years, this gap has mainly been closed through the provision of international assistance. This reflects both North Korean political interests - why pay for something that can be obtained for free? - and the political interests of Western governments, most prominently that of the United States, which face less domestic resistance to providing in-kind "humanitarian relief" to North Korea than straight aid to the Kim Jong-il regime.
In addition to food, North Korea needs energy. It is reliant on imported oil to generate fuels and fertilizer for use in transportation and agriculture. Electricity is mainly generated using coal and hydropower. Generation has been hampered by difficulties in extracting increasingly inaccessible and low quality domestic coal reserves. Beyond this problem, the power grid (largely underground for security purposes) is said to suffer from extraordinarily large transmission losses. The 1994 Agreed Framework between North Korea and the United States provides for the construction of two light water reactors and the provision of oil in the interim. The problem is that this is essentially a diplomatic agreement over North Korea's nuclear program, and does not really address the true needs of the North Korean economy. From an economic standpoint, it would be better to renegotiate the Agreed Framework, scrapping the costly light water reactors, and instead building more cost-effective electrical generating systems, refurbishing the existing electrical grid, and building the necessary infrastructure that would allow North Korea to export electricity to South Korea and China, and thereby earn foreign exchange.14 Nevertheless, if these estimates are correct and the Framework Agreement as negotiated is fully implemented, the actual cost of purchasing the estimated shortfalls in grain and energy inputs, as well as desperately needed supplies of fertilizers, pharmaceuticals, etc. might not be very large, less than $1 billion dollars (Michell, 1998). Assuming that Hyundai makes its payments, the Mt. Kumgang tourism deal guarantees North Korea nearly $150 million annually over the relevant time period. This is a minimum. North Korea receives a payment per visitor. If Hyundai were to fill all the berths on its ships, perhaps by greatly increasing the number of Japanese tourists, North Korea would stand to net approximately $450 million per year - enough to cover its grain deficit on commercial terms. Moreover, other South Korean firms have expressed interest in similar tourist ventures. If the North Koreans went through with the other projects in the Hyundai agreement, including the establishment of a new SEZ at Kaesong, this could generate additional revenues.
These figures refer to recurrent flow expenditures. In addition, there are one-time needs to rehabilitate the North Korean infrastructure, and a variety of organizations have come up with estimates of what this might entail. To use a Seoul metaphor, to a certain extent it depends on whether one takes the black (expensive) taxi or the silver (cheap) one. For example, Williams, Hayes, and Von Hippel (1999) estimate that a rural energy rehabilitation program would cost about $2-3 billion over five years. Their estimated price tag for a more comprehensive economy-wide program is $20-50 billion over 20 years. The Construction and Economic Research Institute of Korea, a think-tank affiliated with the Ministry of Construction has estimated that the North Korean infrastructure is at around South Korea's 1975 level, and that it would cost more than $6 billion to bring it up to South Korea's 1990 level. Hong (2000) estimates that transfers on the order of 2-4 percent of South Korean GDP would be needed for an extended period of time to raise the level of North Korea's infrastructure to South Korea's 1980 level.
For $2 billion annually, one could undertake a fairly bare-bones reconstruction program in North Korea that would generate rising living standards and possibly reduce discontent and contribute to political stability, though one should be careful about making too hasty a linkage between material prosperity and political stability. Around half of this would be for recurrent flow consumption expenditures, and around half would be for industrial and infrastructural investments that could be self-financed through export revenues. Most of this trade would be with South Korea and Japan, with China and the US playing smaller roles - even with the US partially lifting its embargo against North Korea in June 2000. Thus the necessary recurrent external financing needs would be around $1 billion annually.
Where could this money come from? The government of South Korea has set up a special development fund, but the resources are far too small to meet the North's rehabilitation needs. Instead, the single biggest potential source of additional financing would be the resolution of North Korea's post-colonial claims against Japan. This issue was raised by former US Secretary of Defense William Perry during his 1999 visit to Pyongyang. The Japanese government paid the South Korean government $800 million in compensation for colonial and wartime activities at the time of normalization of diplomatic relations in 1965, with $300 million in the form of grants, $200 million in development assistance loans, and $300 million in commercial credits. The North Korean government expects similar compensation. Adjusting the South Korean payment for differences in population, accrued interest, inflation and appreciation of the yen since 1965, one obtains a figure in excess of $20 billion.15 An additional issue raised by the North Koreans that was not included in the South Korean package is compensation for "comfort women" who were pressed into sexual slavery during the Second World War. Reputedly, settlement figures on the order of $5-8 billion have been discussed within the Japanese government. In comparison, Yi Chong-hyok, Vice Chairman of the Korea Asia-Pacific Peace Committee, a KWP organization, in remarks before a Washington audience in 1996 indicated that $10 billion would be the minimum bound for compensation. Japan will certainly argue that its food aid and its one billion dollar contribution to the Korean Peninsula Energy Development Organization (KEDO) should be counted against this charge. Some have speculated that Japan will even try to claim credit for the costs of recapitalizing bankrupt Chochongryun-controlled financial institutions in Japan. In any event, such sums, properly deployed, could go a long way in restoring North Korea creditworthiness and financing economic modernization.
If North Korea were to accept the Perry review's terms of engagement, another carrot that the US, Japan, and South Korea could hold out would be membership in the international financial organizations and the prospect of multilateral economic assistance. Pyongyang has periodically expressed interest in joining the International Monetary Fund (IMF), World Bank, and Asian Development Bank (ADB), and formally applied to join the ADB in August 2000. Membership talks have never made much progress, however, for they have snagged on North Korea's unwillingness to permit the kind of access to economic data and information required for membership in these organizations, its position on the US list of states supporting terrorism, and Japanese opposition relating to unresolved political issues, most notably the alleged kidnapping of Japanese citizens.16 Under normal circumstances, if North Korea were to join these organizations, in the absence of considerable reorientation in domestic economic policies, it would be unlikely that the multilateral development banks would make significant loans. However, given the political importance of North Korea to the US and Japan (influential shareholders in the World Bank, and the dominant shareholders in the ADB), one would expect that North Korea might receive favorable treatment.17 Technical advice and assistance would really be more important than direct lending activities, which would ultimately only complement the activities of private investors. Working from the case of Vietnam (another Asian transitional economy where the government undertook rapid economic reforms) and scaling down the multilateral development banks' lending program for the smaller size of the North Korean population, one obtains lending on a scale of $150-250 million annually. Not trivial, but not enough to finance even a bare-bones recovery program. More money might be available if the US, Japan, South Korea and others set up a special fund for North Korea at the World Bank or ADB.18 Such a fund might be a particularly useful way of politically laundering Japanese reparations. It is possible that under some circumstances North Korea could obtain international financial institution loans even if it were not a member.19 North Korea was invited to the 2000 joint annual meetings of the World Bank and IMF, but declined to attend. In any event, the settlement of post-colonial claims with Japan would dwarf anything North Korea could expect from the multilateral development banks.
Whether the events of 2000-1 mark a fundamental reorientation of North Korean policy is a critical issue. It could be that the Kim Jong-il regime has made the calculation that the best way to preserve their own power and perquisites within the North Korean system is to constructively engage South Korea and the rest of the world, and that moving down the path of economic reform, though risky, presents them with the highest likelihood of ultimate success in preserving themselves within their system. Or, it could be purely opportunistic.
How can we tell? Despite the reported stabilization of the economy (or even its revival), and revenues from the Hyundai deal, North Korea has increased its reliance on international food assistance. The share of food imported into North Korea has risen from nil in 1994 more than 80 percent today. In other words, concessional assistance has almost completely crowded out imports on commercial terms. Food is fungible and food aid acts as implicit balance of payments support - funds that would have otherwise been expended on food can be spent on other items. The issue is then the preferences of the regime, and in the case of North Korea, there is reason for unease. Although it is possible, if one looks hard enough, to find phraseology in North Korean official statements that could be interpreted as supporting the notion of economic reform, in contrast, North Korean official statements are replete with straightforward statements of its "military-first" policy.20
So what are the policy implications of this? From the standpoint of South Korea, Kim Dae-jung is fundamentally correct that the focus of policy should be aimed at supporting the constructive transformation of the North. Militarily, North Korea already holds Seoul hostage with its forward-deployed artillery. The South Koreans might as well engage North Korea in an attempt to reduce tensions and ultimately achieve reconciliation and unification, because the marginal increase in North Korea's threat capability that might be achieved through economic reform is relatively small. The South Koreans are already over that Rubicon.
Therefore the goal of the South Korea should be to domesticate North Korea, pursuing a two-track strategy of trying to defang it militarily while at the same time rehabilitating its economy. The problem from the standpoint of South Korea is the impact that increased integration with North Korea could have on the South Korean economy. The financial crisis has at least temporarily reversed a 20-year trend toward reduced direct state involvement in the South Korean economy. As a consequence of its increased presence in the financial sector and other, more indirect levers on power, the South Korean state has a bigger influence on strategic decisions by the chaebol than it did on the eve of the crisis. The difficulty is that despite the good intentions of the South Korean government, politics and economics are inseparable in the North - even in theory. Any significant interchange with the North will be highly politicized. The South Korean government inevitably will be tempted to directly intervene in the economy to promote its foreign policy goals.21
In this light, South Korea should promote two goals in its dealings with the North: transparency and the transformation of the North Korean system. With regard to the first goal, economic integration between the North and South might convey positive externalities to South Korea and the social rate of return on South Korean investment in the North might exceed the private rate of return on such investment. As a consequence, there is a public policy justification for encouraging investment in the North. It would be better though, to introduce broad tax incentives for investment in the North than to use the state's influence over the financial system to encourage such investment on an ad hoc basis. The notion behind a tax-based policy would be to divorce the overarching societal goal of investment in the North from state influence on particular investment decisions. The advantage of such an approach is that it would preserve the microeconomic efficiency of private firms selecting among potential investment projects on the basis of expected rates of return, while taking the broader social imperative to encourage such investment into account.
With respect to the second goal, one can imagine a hierarchy of modalities of engagement. The worst would be projects such as the Mt. Kumgang project, which can literally and figuratively be fenced off from the rest of the North Korean economy and society and offer little prospect of structural transformation. Given the historical enmity and distrust between the North and the South, the Mt. Kumgang project may have been a necessary first step to build confidence and trust. But having successfully made that step, future projects should be evaluated with a more critical eye.
Marginally preferable to the Mt. Kumgang project would be mining concessions or special economic zones in remote areas such as Rajin-Sonbong. These are classic enclave economies with little prospect for spillover into the broader society.
Industrial parks, bonded warehouses, and other preferential investment zones in urban areas would be preferable, and free investment by South Korean firms throughout the country would be the best of all. The latter would not only maximize the contact between North and South Koreans (and thus maximize demonstration or educational effects with respect to the operation of a market economy), free investment would create competition between local authorities to attract investment.
The point is that North Korea faces a fundamentally supportive international environment. South Korea, Japan, China, even the US want to see a less belligerent North Korea survive until a consensual process of reconciliation and unification can take place on the Korean peninsula. The three questions are whether North Korea is willing to change, whether it is capable of successfully managing change, and to what purposes would it apply the fruits of change. I am hopeful on the first question, skeptical on the second, and wary about the third. I believe that the most likely outcome is a kind of muddling through in which the regime makes a series of ad hoc adjustments while supported by external powers that would prefer to see a less belligerent North Korea muddle along to the risks of instability or collapse. The outcome could well be what I have described elsewhere as "apparatchik capitalism," in which the political elite would use their control over state power to channel the lion's share of rents generated by a partially marketized and non-transparent economy to themselves.22
Agriculture, forestry, and fishing
Mining and quarrying
Electricity, gas, and water
Wholesale and retail trade
Transport, storage, and communication
Finance, real estate, and business services
Others (including Mt. Kumgang)
Heavy and chemical industry
Source: Bank of Korea.
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Williams, James H., Peter Hayes, and David Von Hippel. 1999. "Fuel and Famine: North Korea's Rural Energy Crisis," paper presented to the Pentagon Study Group on Japan and Northeast Asia, Washington, 22 October.
3. See, for example, Oxford Analytica, 9 May 2000 and Eberstadt (2000). One explanation for the unusual timing of the BOK announcement is that its statisticians had undertaken a rebasing of base years and this contributed to delay in releasing their estimate.
4. Indeed, Eberstadt (2000) argues that the BOK used high-end estimates of North Korean agricultural output to calculate its figure, and if it had used other existing official estimates, it would have concluded that there had been no growth at all in the North Korean economy in 1999.
6. See FAO (2000) for its statement on North Korea. Noland, Robinson, and Wang (2000b) provide a more complete analysis of famine recovery strategies. A simple cross-national comparison might be instructive in this regard. At its peak, most observers believe that the North produced about 6 million metric tons of grain. This fell by roughly half by 1996 (Noland, 2000, Table 5.1). In comparison, Morocco also typically produces around 6 million metric tons, but bad weather in 1999 knocked domestic production down to around 1.5 million metric tons, a decline of roughly three-quarters-more than the drop experienced in the North Korean case. While times have been hard, there is no famine in Morocco, however. The Moroccan food shortfall has been closed by importing food on commercial terms. See also Kim, Lee, and Sumner (1998), Smith (1998), and Smith and Huang (2000), for further analyses of the North Korean food situation.
9. The possibility of a second Hyundai-developed special economic zone (SEZ), located at Tongchon, on the east coast near Mt. Kumgang, has also been reported, as have the establishment of another SEZ at Shinuiju.
10. North Korea and Hyundai have been in conflict over Hyundai's desire to significantly increase the number of tourists that it brings to Mt. Kumgang by including large numbers of non-Koreans. In September 2000 the two sides agreed to begin permitting a limited number of Japanese to take part in Hyundai's tours.
12. The dynastic aspect of the regime could convey certain short-run advantages, however. Presumably Kim Jong-il will claim that in private conversations Kim Il-sung expressed views conveniently consistent with whatever policy Kim fils wishes to pursue.
16. Under US law, the US executive directors at the development banks could not vote in favor of extending loans to North Korea until it was removed from the list of countries engaging in state sponsored terrorism. At the ADB annual meeting in May 2000, US Treasury official Ted Truman reportedly stated that Aour position on membership is unchanged. Both because our own legislation requires us to do so [and] because North Korea is an international terrorist stateYas long as that situation prevails and the North Korean regime is one which is fundamentally incompatible with the principles of institutions such as the ADB, we would oppose membership" (Agence France Press, 7 May 2000).
17. World Bank President James Wolfensohn already signaled as much, writing in a July 2000 letter to South Korean President Kim Dae-jung that AWe at the World Bank stand ready to support inter-Korean economic cooperation. We hope to assist in the development of North Korea, within our capacity and mandate, whenever the North Korean authorities are ready to work with us."
19. For example, the World Bank maintains a special program for peace and sustainable development in the Middle East, through which it makes loans in the areas controlled by the Palestinian Authority. It also has adopted a policy that allows it to assist countries that are emerging from crises even though they are not members in good standing of the Bank. This policy was adopted after the Bank was precluded from lending to Cambodia because of a debt arrearage problem. The key attributes in these cases appear to be a cooperative recipient government and strong support from major Bank shareholders. An April 2000 statement to this effect by the IMF resident representative in Seoul, David T. Coe, was immediately denounced by Rep. James Saxton (R-New Jersey).
20. According to the 1999 South Korean National Defense White Paper, North Korea increased its reserves of chemical weapons, boosted KPA manpower by 10,000 troops, created a missile division, and added 10 submarines to its fleet. In August 1999, it was revealed that North Korea had purchased roughly 40 aging MiG-21 fighters and eight military helicopters from Kazakhstan. It was subsequently reported that North Korea was trying to obtain more advanced MiG-29 and SU-30 fighters as well. In September 1999, a classified US Air Force report allegedly describing continued North Korean work on its Taepodong missile was leaked to the press. In October, in testimony before the Senate Armed Forces Committee General Thomas Schwartz, the newly appointed commander-designate of US Forces Korea stated that North Korea had accelerated its arms build-up and was forward-deploying artillery and rocket-launchers in underground facilities. In March 2000, Admiral Dennis Blair, Commander-in-Chief US Pacific Forces, indicated that North Korean military exercises during the winter of 1999-2000 had been the most extensive in recent years. Other US military sources indicate that the 2000 summer exercise cycle, too, was the most extensive in years. In the 2000 White Paper, the South Korean National Defense ministry indicated that North Korea had deployed 500 short-range missiles and other artillery near the border with South Korea.
21. A good example of this would be the travails of Hyundai, which narrowly averted bankruptcy in November 2000 when state-dominated banks extended it emergency loans. Hyundai is one of the prime contractors on the KEDO project and the industrial park at Kaesong, and could play an important role in inter-Korean economic integration. The risk, of course, is that the South Korean government will be tempted to reward Hyundai or other firms that do its bidding in the North with preferential treatment. Indeed, some observers go so far as to argue that given President Kim's deep personal commitment to his engagement policy, that Hyundai undertook its projects in the North with the intent of creating moral hazard in which the government would be forced to bail it out should it encounter financial trouble. In fairness, most observers believe that the HEC bail-out was related more to unemployment concerns and the Daewoo Motors bankruptcy (the same week) than to Northern policy.