The Evolving North Korean Financial System

July 21, 2016 7:00 AM

North Korea rode the global commodities boom up, and now is being adversely affected by slumping world commodities prices. After a period of improving living standards and rising expectations, stagnation could be threatening to political stability. With one of the main drivers of economic growth over the last decade going into reverse, and bereft of conventional tools of macroeconomic policy management, what is a young monarch to do? Toleration of further de facto relaxation on domestic market activity is one potential safety valve.

Such is the context for a recent rash of analyses on the evolution of the North Korean financial sector. The basic outlines of the story are well-known: for most of its history, North Korea had a classic monobank system in which the Central Bank played multiple roles including those of both a central and commercial bank. According to recent reports by KIEP and the KEXIM Bank, that system began to come apart during the famine period when economic activity nosedived and the state struggled to fulfill basic functions. Money-changing evolved into loansharking, often using police or military personnel as collection agents, amid the chaos. The formal system was dealt a further blow by the 2009 currency debacle which dramatically deepened distrust in the state-run financial system. The fall in economic activity that accompanied the botched currency reform reflected in part how deeply the state system was enmeshed with informal finance—even prestige projects ground to a halt when state owned construction companies could not procure necessary inputs such as cement, due to the collapse of private sector activities.

The upshot is that informal finance was effectively decriminalized when the state was unable to provide financing to SOEs as it had done in the past, or completely cover the costs of prestige projects, and had to turn to the donju to cover financial gaps. Daily NK provides the illustrative example of a suspended project in Hoeryong begun in 2010 as part of an idolization campaign for Kim Jong-il’s wife, Kim Jong-suk. According to Daily NK reporting, earlier this year the state authorized the project to be completed by designated individuals who were permitted to retain a share of earnings from the project to compensate them for risk. Construction activity picked up in March as the donju were mobilized.

The enactment of a Central Bank Law and Commercial Banking Law earlier this year creates the institutional space for a two-tier banking system that would provide for further institutional differentiation such as the creation of policy banks, commercial banks, and other financial institutions. The issue then would be bringing the donju and informal lending into the newly expanded formal financial system. The KIEP report envisions donju managing formal sector financial institutions.

But the experiences of other transitional economies such as China and Vietnam suggest that passing laws is not enough: a variety of real reforms have to be undertaken to make the system work. The most basic is the maintenance of positive real interest rates for savers/depositors and credible assurance on the availability of withdrawals. This is no small thing for North Korea, where the political leadership has never seemed to grasp credibility issues. The basic banking issues are complicated by the degree of dollarization of the economy (something that China never had to face). What is the going exchange rate, and can the state persuade savers that once they put their hard earned dollars into the account, they will be able to get them back?

This consideration, in turn, raises the issue of exchange rate overvaluation, and the need to bring the official value of the won into alignment with its genuine market value.

The KIEP report goes on to consider the issuance of treasury bonds, including foreign currency denominated bonds. While one could borrow in foreign currencies from domestic residents, KIEP also envisions participation by foreign financial institutions, giving the analysis a bit of an “assume a can opener” air. Even the AIIB seems to have closed the door on North Korean lending for the foreseeable future.

Which brings us to the byungjin line. It is not difficult to imagine further de factor relaxation of internal practices in response to the deterioration of the terms of trade. One might even observe domestic financial reforms. But the external component of financial sector development plans is hamstrung by the deepening confrontation over the North Korean nuclear weapons program. Or as the KIEP report prosaically observes, “It is imperative to realize that such reform plans require the preconditions of remedying distrust towards the government and meeting the terms required to lift the sanctions against North Korea.” Don’t hold your breath. 

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