Yesterday at an East-West Center workshop we presented a preliminary version of the first of two planned papers based on an unprecedented survey of more than 300 Chinese businesses operating in North Korea.
There are essentially two sorts of Chinese enterprises doing business in North Korea: large state-owned enterprises with long-standing relationships with their North Korean counterparts, and a larger number of small, essentially private businesses that restrict themselves primarily to trading activities. Nearly 90 percent of the businesses surveyed report being able to make a profit in North Korea. Nonetheless, Chinese appraisals of the North Korean business environment are generally negative and manifest fear of expropriation of investments made in North Korea. A large majority of the respondents complain about infrastructure issues—most notably historic ban on cell phone use —but respondents also complain about the nature of the regulatory environment, the risk of arbitrary changes in rules and practices, and lack of reliable dispute adjudication. As a result, Chinese enterprises limit their exposure, generally choosing trading over investing, conducting transactions in China, holding their North Korean counterparts to tight settlement terms, and demanding payment primarily in US dollars or Chinese yuan.
Bribery and corruption are pervasive features of the business environment, and might be seen as a rational response to the lack of property rights protection. Bribe payments constitute a political means of assuring protection. However, there is some evidence that firms face a greater likelihood of economic predation as their size increases. The limited scale of many Chinese operations and the reluctance of firms to invest or even to engage in anything more than spot-market transactions appear endogenous to the absence of property rights protection and the existence of widespread corruption.
In the absence of formal institutions for dispute settlement, there is some evidence that Chinese businesses may seek to protect themselves from official predation via informal networks of other firms. Recourse to other firms rather than either North Korean or Chinese authorities may constitute an example of how private traders can use reputational mechanisms to protect themselves. But these arrangements are suboptimal and most firms that have had disputes with their counterparties report a low level of satisfaction with the outcome.
One of the more disturbing results is that businesses' actual experiences in North Korea both with respect to the infrastructure and property rights issues appear to be even more challenging than they expected going in. An open issue is whether the recent North Korean move to establish a one-stop shop for foreign investment approval will reduce or merely centralize the corruption that potential investors face.
In sum, institutional weakness deters integration; deters investment relative to trade; and inhibits normal trade finance. Given the weakness of formal institutions and the apparent reliance on hedging strategies, the rapid growth in exchange that we have seen in recent years may prove self-limiting, as the effectiveness of informal institutions erode and the risk premium rises unless offset by a concomitant strengthening of formal institutions. Institutional improvement would clearly have significant welfare implications, affecting the volume, composition, and financial terms of cross-border exchange.
The paper will go through a peer-review process and should be forthcoming within the next few months. Don’t worry: we will let you know when it does.