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Speeches and Papers

The Economics of Korean Unification

by Marcus Noland, Peterson Institute for International Economics

Paper prepared for Foresight Magazine
February 2000

© Peterson Institute for International Economics


 

North Korea is in its ninth year of economic decline. A famine has claimed the lives of perhaps ten percent of the pre-crisis population. Despite its juche (self-reliance) ideology, the country is increasingly reliant on the beneficence of others. The regime has undertaken a series of hesitant changes in economic policy that appear designed to maximize foreign exchange earnings while minimizing systemic change. These policy innovations include the Rajin-Sonbong special economic zone, the Mt. Kumgang tourism project, the possible establishment of mining concessions, and the possible establishment of new special economic zones and bonded warehouses in the vicinity of Haeju, Nampo, and Wonson.

Whether these actions will be enough to pull North Korea out of its economic decline is another matter, however. 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 generates enough 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. For the last five years, this gap has mainly been closed through the provision of international assistance.

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 economics 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.

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. would not be very large, less than $1 billion dollars. Assuming no more interruptions in service, the Hyundai Mt. Kumgang tourism deal guarantees North Korean 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, North Korea would stand to net approximately $450 million per year—or 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 Haeju, this could generate additional revenues.

For $2 billion annually, one could sufficiently fix the North Korean economy that it would generate rising living standards and presumably reduce discontent. 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 after the US lifts its embargo against North Korea. Thus the necessary recurrent external financing needs would be around $1 billion annually.

 

Financing Basic Needs

Where could this money come from? There are many possibilities, but 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 visit to Pyongyang last year. 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. 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 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). 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 and Japanese opposition relating to unresolved political issues, most notably the alleged kidnaping of Japanese citizens. 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. 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 billion 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. Such a fund might be a particularly useful way of politically laundering Japanese reparations. It is possible that under some circumstances North Korea could access multilateral development bank loans even if it were not a member. 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 which 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. Bank staff have also expressed the view privately that an independent, poor North Korea would probably be able to access more lending than a unified middle-income Korea. Either way, the settlement of post-colonial claims with Japan would dwarf anything North Korea could expect from the multilateral development banks.

 

Collapse

Of course, although this minimalist reform scenario appears relatively attainable, there is no guarantee that such an outcome will be obtained. It is possible, through unlikely, that North Korea will not undertake the policy changes necessary to ensure its own survival, and instead could collapse and be absorbed by South Korea as was the case in Germany. Such a development could greatly change the economic calculus on the Korean peninsula. The relatively cheap minimalist reform scenario depends on the stability of the North Korean state and the consequent ability to maintain enormously different levels of income across the two parts of the Korean peninsula. Were Korean unification to occur, the government would face rising expectations among the populace of the North, and desire to migrate south in search of a better lives. It is possible, though unlikely, that the government could use the Demilitarized Zone as a method of population influx control for an extended period of time while conditions in the North slowly improved. Rather, the political imperative would be to improve conditions in the North rapidly. However, even under a relatively optimistic scenario of moderate, controlled, cross-border migration, and rapid convergence in North Korea toward South Korean levels of productivity, bringing the level of income in North Korea to half that of the South would require a decade and hundreds of billions of dollars of investment — transfers larger in relative terms than in the German case.

This would not be pure "cost," however. Some in South Korea could arguably benefit in this scenario. Investment in the North would earn remitted profits to owners of capital in the South, and the process could be expected to shift the distribution of income away from labor and toward capital. At the same time, there would be shifts in the income distribution among difference classes of labor, with the distribution of income shifting toward higher skilled classes of labor. Another cleavage would be between sectors producing internationally traded goods such as manufactures, and non-traded goods such as construction, with the non-traded goods sector doing relatively better. The bottomline is that if you are a South Korean construction magnate with savings to invest in unification bonds, Korean unification could be very good for you. If you are a low-skilled manufacturing worker, it could be a very different story.

 

Conclusions

One can imagine three broad scenarios: in the first, the North Koreans see the error of their ways, and undertake fundamental economic reform. Although this would be highly desirable, it is also highly unlikely: fundamental reform would unleash enormous economic and social changes and could be highly destabilizing politically. Moreover, prospective reformers in the North would have to deal with their divided country situation — something with which the authorities in China and Vietnam did not have to contend. At the other extreme, the state could simply collapse and be absorbed by South Korea, much like East Germany was absorbed by West Germany. Although this would arguably be an improvement from the status quo, this, too, is not particularly likely: South Korea, Japan, and China, would all prefer to see a domesticated non-threatening North Korea to its collapse and absorption by the South.

The third, and most likely, alternative, is that North Korea continues to muddle along, making ad hoc policy changes as circumstances dictate, and relying on its neighbors for support. The 1999 visit of former US Secretary of Defense William Perry, the resumption of discussions between Japan and North Korea, and the expected visit of a high-ranking North Korean official to Washington in March all point to this "middle way." Yet history is replete with examples of countries that did not go the way their foreign patrons desired. In the case of North Korea, whether the regime is willing and able to make the necessary changes to ensure its own survival is still uncertain.