North East Asia and North Korea: Introduction

  • This special issue of the International Economic Journal includes articles by a very distinguished group of economists on topics that are of crucial importance for the Korean peninsula and for North East Asia. After the death of Kim Jong-il and his succession by Kim Jong-un, questions have been raised anewon the future of the North Korean economy.Will there be reforms towards the market economy in North Korea under the new leadership or must one wait for a collapse of the regime? How to achieve a successful transition to a prosperous market economy? Historically, how to explain the tremendous economic success of South Korea and can it be replicated? How to see future changes in the Korean peninsula in the general East Asian and Northeast Asian context? These are some of the questions analyzed in the articles of this special issue.

    Barry Eichengreen (University of California, Berkeley) looks back at the South Korean economic success in order to understand the inherited strengths and weaknesses inherited from South Korea’s economic transformations in previous decades. A major problem facing all economies early in their development is how to assure capital accumulation when financial markets have not yet developed and companies cannot rely on arms-length market relationships to finance industrial expansion. Three alternative solutions may then be used to ensure capital accumulation: government, business groups or financial institutions. In South Korea, all three played an important role but government played a dominant role in coordinating their activity. The government, for example played a key role in guaranteeing loans to Korean enterprises by foreign banks in the 1960s. The government also played an active role in supporting sectors it wanted to expand, such as heavy industry and chemical industry in the 1970s. The Chaebols gradually played an always larger role in the economy. Initially, their role was very important in South Korea’s development. However, these groups as well as the government bureaucracy, whose role was critical early on in South Korean development, became firmly entrenched after the introduction of democracy. Once South Korea became more developed, these institutions had become ill-adapted to the new needs of a modern South Korean economy. The 1997 crisis shone a light on many of the problems that had accumulated since Park’s assassination. Progress has been done since then on corporate governance and on the divestiture of the Chaebol of their non-core businesses, but more progress needs to be done to modernize South Korea’s institutions. Eichengreen considers radical calls to break up the Chaebol or to get the government out of the economy not to be fruitful or relevant. The issue is how to find ways to further reform South Korea’s institutions to adapt them to the current needs of the economy.

    Jing Ma&Lihui Tian (Nankai University) emphasize the role that the Chinese government has played in dealing with the 1997 and 2008 crisis, supporting the idea that developmental states play an important role in development success.  Whereas market-oriented reform is definitely the reason behind China’s growth miracle, Ma & Tian show that the Chinese government played a key role during two major crisis episodes: the 1997 East Asian crisis and the 2008 crisis, called the ‘American Storm’. The latter represented a huge external demand shock for the Chinese economy. The Chinese government played an aggressive role to stimulate the economy. It responded by cutting interest rates and putting forward a comprehensive fiscal package, following textbook Keynesian recipes with great success. Government ownership of SOEs and of large banks helped the government intervene more directly in the economy. Ma & Tian argue that even though legal institutions are very imperfect in China, government intervention can nevertheless play a very important role in fostering economic development.

    Annette Kim (MIT), analyzes the lessons from Vietnam’s transition in regard to the role of the informal sector and of institutional change. Does the emergence of informal trade by North Korean households, who have to cope in a harsh economic environment, serve as the seed for the emergence of well-functioning market institutions later on or will it be more difficult later on to integrate it in the formal sector once market institutions are established? She sheds light on this question, using the experience of transition in Vietnam, where the South and the North had different initial conditions. One striking finding of her research in Vietnam was the difference in North and South Vietnam associated with the valuation of legal documents in real estate transactions. In South Vietnam, the presence of legal papers documenting ownership titles, in the absence of a true property titling system, had a positive effect on property prices but thiswas not the case in North Vietnam. She points to the differences in social norms in the North and the South, with more rigid social norms in the North, based on centuries of Confucianist tradition, and also to the different attitudes of local government towards the economy, with a more helping attitude in the South than in the North. In NorthKorea, there are not, as yet, positive traces of pro-market social norms or of business-friendly attitudes of government officials. Nevertheless, she suggests that ethnic Chinese living in North Korea, the hwa-gyo, might constitute a social group that could contribute to the development of markets in North Korea, using connections in China and their relationship networks within North Korea.

    Stephan Haggard (University of California San Diego) and Marcus Noland (Peterson Institute for International Economics) analyze the three different modalities of economic integration between North and South Korea. The first is based on processing on commission. It involves the assembling in North Korea of products based on inputs imported from South Korea. The assembled products are then sold in South Korea or on the world market. The second modality   involves arms length relationships between a South Korean and a North Korean business partner. The third modality involves production activity in the Kaesong Industrial Complex in North Korea close to the border with South Korea. Production is done in North Korea with North Korean labor, but all the rest is under the control of South Korean firms. Inputs, management, infrastructure and regulation are provided to a large extent by South Korea. In other words,  manufacturing activity in Kaesong benefits from South Korean institutions. Haggard and Noland argue that North Korea incurs a substantial loss in economic integration with the South due to its bad institutions. They report results from   a survey of 250 firms between November 2009 and March 2010. In contrast to Chinese trade with North Korea, South Korean firms operating in North Korea got their connections more via the South Korean government. Compared with Chinese firms, there are fewer complaints about corruption and also fewer disputes. When they do occur, disputes are settled privately or directly via the North Korean government. South Korean firms entering into economic relations with North Korea are typically young small and medium enterprises in the capital Seoul, benefiting from state support to enter the North Korean market. There is a greater presence of trading than of manufacturing companies. Firms that exit business in North Korea are typically more likely to have a non-Chinese speaking CEO and to lack support from the South Korean government. An interesting finding is that payment settlement terms are stricter in processing on commission relations than in arms-length trade, which are in turn stricter than activities in Kaesong.This reflects the difference in riskiness of these various modalities,which is directly related to the higher exposure to North Korean institutions. Note also that there is very little lending involved in North–South business relations and payments are usually either in US dollars or through barter exchange. Overall, these findings underscore the costs to North Korea of its bad institutions and infrastructure.

    Jehoon Park (University of Incheon) uses tools of comparative analysis to analyze prospect for Northeast Asian integration. In contrast to other socialist economies, North Korea did not collapse after the fall of the Soviet regime.  While strongly suffering from the Soviet collapse, its situation has somewhat improved in recent years, in part thanks to aid from China, despite sanctions, but also thanks to partial private sector development. The biggest change associated to the succession in leadership is that the North Korean leadership is now more collective after Kim Jong-il’s death. Most likely, notmuch change can be expected before Kim Jong-un consolidates his power. Park then devotes most of his article to analyzing prospects for economic integration not only between the two Koreas but in North East Asia more generally. He contrasts a long-term evolutionary model of integration based mostly on market transactions with an integration model that involves more state intervention and is more focused on short-term issues. He emphasizes the need to widen our views on models of integration and to consider the role of other actors such as intellectuals and local governments. Crises can help make leaps forward in integration. The 2008 crisis has generated regular trilateral summits in Asia between China, Japan and South Korea. The North Korean threat itself has generated the ‘six Party Talk’ institutions, which can be seen as an instrument of integration in the region. Similarly, the 2011 tsunami in Japan has led to forms of solidarity and cooperation in Asia. Finally,  Park discusses scenarios of sequencing involving the transition in North Korea (T), unification of both Koreas (U) and economic integration (I). Most likely, a T-I-U or a T-U-I scenario of sequencing will be observed. He, however, would prefer an I-T-U scenario. Regional integration would indeed secure more peaceful unification between the two Koreas later on. Moreover, risky events in North Korea could generate undesirable international tension in North East Asia. He also advocates the equivalent of a Marshall Plan for the whole North East Asian region given the various pockets of poverty in the region.

    Sung Min Mun (Bank of Korea) and Byoung Hark Yoo (Soongsil University) focus on the important issue of wage policy following a Korean unification. Following German unification, the conversion of one Ostmark for one Deutsche  Mark killed the competitiveness of East German products overnight as East German workers got wages close in level to those of West German workers while productivity was much lower than in West Germany. Obviously, South Korean  policy-makers would like to avoid the mistakes of German unification. The paper therefore explores quantitatively various scenarios of wage trajectories in the case of economic transition in North Korea. Three different unification scenarios are discussed: that of a unitary state (U), a federation (F) or North Korea becoming a Special Administrative Region (SAR), in the spirit of the status of Hong Kong relative to China. The main focus, in each of these three scenarios is the wage productivity gap between North and South Korea. Since South Korea is a unitary state, plain unification would entail the U scenario. In that case, the adoption of minimum wage policies from South Korea would be a catastrophe. Given the much lower productivity in North Korea, wages should be expected to be in the range of 73,100 to 158,400 won per month, a much lower level than the minimum wage in South Korea. Adopting South Korean minimum wages would thus create a massive wage hike that would kill competitiveness of North Korean firms. Under this scenario, economic performance in North Korea is expected to be worse than that in East Germany with an unemployment rate at 36.4% compared with 17.5% in East Germany. The fiscal burden on the South Korean government would accordingly also be heavier, due to the fiscal cost of paying very large unemployment benefits. Under the F scenario, the effects of an East German type scenario are examined. The results are also similar to the East German experience in terms of growth and unemployment. North Koreawould grow somewhat faster due to the lowinitial level of its capital stock. The most favorable scenario is that of the SAR status for North Korea. In the simulations run by the authors, it is assumed that some wage catch up occurs in North Korea but the wage productivity gap between North and South remains low at 1%. In this case, unemployment in North Korea can be kept below 2% and the fiscal burden of unification appears to be less than 30% of the federation scenario. Mun and Yoo show us how critical wage policies will be under transition and how important it will be to prevent a too rapid wage catch up in North Korea.

    Max St. Brown (Washington State University), Seung Mo Choi (International Monetary Fund) and Hyung Seok Kim (Sogang University) also come up with quantitative simulations of the impact of unification on both North and South   Korea.They use a Parente-Prescott type of catch up model including factor mobility. Their baseline scenario is similar to the East German scenario in terms of model parameters. They find that after 10 years North Korea’s GDP per capita would be more than ten times larger what it would be without transition. South Korea on the other hand would have a somewhat lower GDP per capita after ten years ($42,334 compared with $48,801 without integration). Three forces are important in the model: (1) the pace of total factor productivity (TFP) following unification; (2) labor migration from North to South Korea; (3) capital transfers from South to North Korea. The lower the TFP deceleration in South Korea and the lower the migration and capital transfers, the lower the losses for South Korea. North Korea and Korea as awhole, however, gain from unification. The most sensitive factor in their model is however the deceleration in TFP, which need not occur following Korean unification but which did occur in West Germany.

    Paul Hare (Heriot-Watt University) explores the possibility of significant reforms that could be decided before a regime change in North Korea, even though this seems politically unlikely. North Korea would benefit from reducing defense expenditures and net exports and from investing in the improvement of its agriculture. Technically, this should happen via modern inputs of fertilizers and pesticides, together with improved seeds and livestock, and better knowledge. In order for this to happen, farmers need to be given incentives to innovate and improve productivity. Devaluation can help the Korean economy by contributing to a reorientation of its exports and imports to adjust finally, after more than 20 years of delay, to the reality of the collapse of trade with the Soviet Union. Hare’s papers goes deeply into the kind of detailed institutional changes that would be necessary to change the incentives of farmers and entrepreneurs but also insists that changes cannot be seen in isolation but as a package. As concerns the state apparatus, the question is not so much that of rolling back the state but of changing it to acquire new capacities such as managing the macro-economy, the social safety net, regulations, banking supervision, competition policy, entry and exit of firms, protection of property rights, etc. Firms must learn new technologies through joint ventures and foreign direct investment. Harewarns against the dangers of an immediate merger with SouthKorea and recommends the establishment of an interim administration in the North in case of regime collapse.

    Byung-Yeon Kim (Seoul National University) and Gerard Roland (University of California, Berkeley) compare two scenarios of transition, one under regime collapse, and one assuming that the leadership decides to engage in Chinese-style transition, leaving the political regime unchanged. Both scenarios are similar in many respects. The credibility of institutional change is weaker under the Chinese-style scenario. One major difference is that in the latter case, unification of Korea might in the long run be more difficult to achieve because economic success in North Korea could lead to more successful military buildup later on. Tensions between North and South Korea could in the long run become stronger, not weaker under such a scenario. One particularity of their proposals is the idea, especially under a collapse scenario, to distribute property titles to all North Korean citizens. In the countryside, this would be property over land and in urban areas, titles over dwellings. North Korean citizens migrating to the South would lose rights to these titles. These titles would not be tradable for a number of years. Holding these titles should encourage entrepreneurial initiatives in the North (private farming plots, little shops and workshops in urban areas) coupled with entrepreneurship loan programs so as to unleash private initiative. Kim and Roland emphasize the strategic role of good relations between China and South Korea to make any transition scenario successful.

    Overall, this issue contains a number of insightful articles from very distinguished scholars with many interesting and exciting ideas. We hope that readers will benefit from them and that this may stimulate further research and discussions.  Hopefully, these insights may prove useful for policy-making when the difficult but important tasks of initiating fundamental economic changes in North Korea will be on the immediate agenda of policy-makers.