Economic Integration and Cooperation on the Korean Peninsula

This paper was written while the author was a POSCO Fellow at the East-West Center.

Introduction

North and South Korea appear to have embarked on a process of national reconciliation. (The verb "appear" is used intentionally-a certain degree of skepticism about the motivations of the two governments is warranted.) Nevertheless, it is a worthwhile intellectual exercise to take the two governments at face value, and think about what national reconciliation could mean in economic terms.

The starting points are not particularly auspicious. South Korea continues to grapple with the aftershocks of the financial crisis that shook the country in 1997-98. For a decade the economy of North Korea has been in a state of decline. Its political system experienced a shock with the 1994 death of founding leader Kim Il-sung, and the accession to power of his son Kim Jong-il. In the intervening years, North Korea pursued essentially two coping strategies. The first strategy has been the pursuit of "one-off" projects to generate foreign exchange without affecting the systemic organization of the economy. These projects would include the Rajin-Sonbong special economic zone (SEZ) and the Mt. Kumgang tourism project. The second has been the use of implicit or explicit threats in developing nuclear weapon and missile capabilities in order to extract resources from the rest of the world. The 1994 Agreed Framework between North Korea and the United States has resulted in the establishment of a multinational consortium to build the North two light water nuclear reactors (LWRs) and provide heavy fuel oil during the period prior to completion of the reactor project. Brinkmanship has been used to extract additional resources from the world community in the guise of humanitarian aid to the North's food problems. Indeed, North Korea is now the largest recipient of US aid in Asia.

This strategy of minimal economic reform combined with opportunistic resource extraction may have begun to change in the aftermath of North Korea's missile non-test in 1999.¹ In August 1998 North Korea fired a multi-stage rocket over Japan. Ironically, this missile test, together with the pro-active reconciliation policies toward Japan pursued by South Korean President Kim Dae-jung, contributed to a greatly strengthened trilateral relationship between the United States, Japan, and South Korea. This was manifested during the policy review led by former US Defense Secretary William Perry, and a series of self-reinforcing actions of the three allies.

In August 1999, the North Koreans began a build-up to a second missile launch while demanding compensation from Japan. The Japanese did not blink, refusing to pay what amounted to an extortionist's ransom. Having been stiffed by the Japanese, the North Koreans in essence chose their next best option-to re-engage in negotiations with the United States over their missile program. Those negotiations yielded a North Korean moratorium on testing in return for a lifting of US economic sanctions-but no significant monetary compensation. Having failed to extract significant financial commitments from either Japan or the United States, the North Koreans were forced to turn to South Korea, restarting the lapsed North-South dialogue-which the United States had made a precondition for normalization of relations in the 1994 Agreed Framework.

The intervening months have witnessed a flurry of North Korean diplomatic activity, including normalization of relations with a number of countries, and culminating in the June 2000 North-South summit. These developments raise three obvious questions. First, having consolidated power internally, do the events of the past year herald a fundamental strategic reorientation on the part of a newly confident Kim Jong-il, or is this simply an elaborate tactical maneuver? If the answer is affirmative-that is, these developments signal a fundamental change on the part of the North Koreans, are they capable of successfully reforming their system? Finally, suppose the North Koreans did successfully reform their economy. What are their ultimate intentions? To what purpose would the gains from economic reform be applied-to the pressing material needs of the North Korean people or to other purposes, such as military modernization?

One cannot sensibly discuss issues of economic integration and cooperation without answering these questions, and to preview my conclusions, I will argue that the evidence on these issues is not unambiguous. Nevertheless, in keeping with the theme of this conference, I will focus on the possibility of national reconciliation through a protracted, negotiated, process yielding some kind of confederation or "one nation, two systems" outcome. This is the official position of both the North and South Korean governments today as reaffirmed in the June 2000 summit. Noland (2000) discusses some other possible outcomes in detail.

Consensual Reconciliation

Both North and South Korea have expressed a desire for a consensual unification of the peninsula. Kim Dae-jung has repeatedly indicated his disinterest in undermining the DPRK and has instead called for peaceful coexistence. In his 2000 New Year's message, he called for commencement of installation of the core components of the promised light water reactors, development of industrial estates on North Korea's Yellow Sea coast, expansion of the Mt. Kumgang tourism project, increase in processing on commission trade (the primary modality for inter-Korean trade), and improvement in transportation systems linking the North and the South. Three months later in his "Berlin Declaration" of March 2000, President Kim indicated that the South Korean government was willing to directly support the economic rehabilitation of the North. Prior to the June summit South Korea sent 200,000 tons of fertilizer, valued at roughly $60 million to the North, and afterward sent another 100,000 tons. "Economic cooperation" was identified as one of the priorities for action in the June 2000 summit declaration, and working level groups are expected to undertake negotiations relating to settlement of payments, investment protection, avoidance of double taxation, and arbitration of disputes, along the lines specified in the 1991 Basic Accord and supplemental agreement. The South Korean unification plan is gradual in the extreme, envisioning a process of unification lasting two generations. It put forward a plan for federation at the summit.

For its part, North Korea has proposed a Confederal Republic of Koryo to be governed by a national assembly consisting of an equal number of representatives from North and South Korea.² The statement in a 1999 meeting at the Council of Foreign Relations by North Korean Foreign Minister Paek Nam-sun that North Korea could consider a "one country, two systems" model along the lines of Hong Kong and China could be interpreted as a signal that North Korea was open to this kind of engagement. South Korean National Intelligence Service head Lim Dong-won told a press conference in June 2000 that the Korean Workers Party plans to remove the section of its charter stating that "our party's immediate objective is to complete national liberation under a revolutionary people's democracy and to build a juche society under communism," signaling a symmetric scaling back of unification ambitions.

Since the summit the two countries have expanded economic cooperation. Inter-ministerial talks have occurred, and a joint economic coordinating committee has been established to deal with such issues as double taxation and investment guarantees, re-establishment of transportation links across the DMZ, and joint flood control.

In a formal sense, one can imagine a series of progressively deeper steps of cooperation and integration that the states could undertake. The first steps would presumably be the completion of the aforementioned agreements to create a legal framework for exchange between the two countries, and perhaps some state-led "economic confidence-building measures." In the latter category, Kim Dae-jung has already expressed interest in opening up two rail lines (one along the east coast and one along the west).³ In economic terms, South Korea today is effectively an island, and the successful opening up of trans-North Korea rail links would allow South Korean firms to transport goods to Europe and other destinations over land. These developments would promote private sector-led economic exchange and promote economic integration between the two economies (and indeed contribute to regional integration more generally).

Once basic economic exchange has been regularized between the two countries, the next formal step in economic integration would be the formation of a free trade area, freeing trade between the two Koreas, but permitting each to restrict trade with third parties according to their own interests. This would be equivalent to the North American Free Trade Agreement (NAFTA) in which trade is unencumbered among the United States, Canada, and Mexico, but each country maintains its own trade policies with respect to nonmembers. Even this first step would appear to be far beyond anything that can be seriously expected in the medium-run. The next step would be the formation of a customs union, which would involve applying a common policy to trade with third parties. This would be akin to the European Economic Community (EEC).

Economic union would be a deeper form of integration, permitting the free movement of factors (labor and capital) as well as goods across borders, as exists in the European Union today. A monetary union would involve the adoption of a single currency, as is in process in some EU member states today. A social union would involve the adoption of common labor and social welfare policies in the two states. The final stage would be political union and the surrender of independent claims on sovereignty. The European Union has managed to create an economic union and is in the process of forging social and political union. Within this schema there are differing degrees of surrender of local authority to central governments. Presumably given the radically different social and political systems of North and South Korea, any form of consensual political integration would involve the maintenance of extensive local autonomy. Indeed, given the highly centralized nature of the governing systems of both North and South Korea, issues of local autonomy and control would presumably be highly contentious under any unification scheme.

Whither North Korea?

Thus the prerequisites for a consensual unification would be maintenance of two independent states and a sufficient degree of convergence of economic and political practices to make the outcome plausible. In the case at hand, this means generating sufficient reform in the North's economic and political system to make some degree of integration with the South sustainable.

The April 2000 North-South summit announcement stunned the world. The timing, coming three days before South Korean national assembly elections in which Kim Dae-jung's party trailed in the polls, raised questions about whether this rapprochement was genuine, or whether it might be no more than a tactical move on the part of the North Koreans timed to extract maximal concessions out of an electorally weak Kim Dae-jung and to buy some insurance against a possibly harder line US administration taking office in January 2001. Skepticism was fed by North Korea's history of extorting resources from foreigners to secure its participation in diplomatic activities, and South Korea's own history of "checkbook diplomacy," most notably in its the process of normalizing relations with the USSR. Given the Berlin Declaration and Kim Dae-jung's willingness to directly underwrite the economic rehabilitation of the North, many continue to speculate as to what President Kim may have promised the North in order to secure the pre-election summit announcement.

In this light, the first question then is whether the North Koreans are serious about pursuing, at a minimum, economic reform, or whether diplomatic activity during recent months amounts to an elaborate feint, undertaken to, in effect, diversify the North Korean's aid donor base.

The evidence-what the North Koreans say, what they sign, and what they do-is mixed. One bit of evidence can be adduced from North Korean statements. 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, which 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."⁴

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. During Supreme People's Assembly leader Kim Yong-nam's visit to Beijing in 1999, the two countries adopted an "I'm OK, you're OK" formulation in which they agreed to pursue socialism according to their respective national characteristics.

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 the Chinese adopting their natural role as mentors in this regard.

That said, Kim's remarks have not been reported in the North Korean press, and indeed, the week after Kim returned from China, North Korean television re-broadcast the "opening" as a "Trojan horse tasked with destabilizing socialism" editorial, which some have interpreted as indicating that Kim's Beijing remarks were insincere and/or made under economic duress. This evaluation may be too harsh. It is probably naïve to project onto Kim Jong-il the belief that a firewall can be maintained between statements widely broadcast in China and elsewhere and what reaches the North Korean elite. Moreover, politically it is hard to imagine that Kim could travel onto foreign soil, and then, in effect, announce that the previous fifty years of economic policy (undertaken by his deified father) was flawed. Rather, it is more likely that the North Koreans are searching for a face-saving way to introduce these ideas into domestic discourse. Admittedly, this is speculation, however. All we know for sure is that Kim Jong-il traveled to Beijing and made a series of statements at odds with longstanding North Korean positions and that these remarks have not been reported by the North Korean media.

Another piece of evidence can be adduced from what the North Koreans have signed. Since the summit they have entered into agreements with the South Koreans on investment and taxation issues, though some knowledgeable observers question whether the North Koreans fully understand the implications of these agreements.

The proof of the pudding, however, is in the eating, and the most important issue is what the North Koreans actually do. 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. Establishment of the industrial park has been delayed by a dispute over the proposed location. Kim Jong-il reportedly has expressed a preference for Shinuiju over Haeju, despite the latter's greater attractiveness as an economic hub. Some (e.g. Moon, 2000) have 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. The possibility of a second Hyundai-developed SEZ, located at Tongchon, on the east coast near Mt. Kumgang, has also been reported. The North Koreans have also begun to relax their stance with regard to Japanese tourists visiting Mt. Kumgang which would have obvious implications for Hyundai's bottomline.⁵

Only time will tell what the North Koreans' intentions are. It is hard to argue though, that recent developments reduce the likelihood of consensual integration.

Assuming that the North Koreans have made the decision to undertake economic reform, the issue then is whether they are capable of successfully managing reform. In this regard they face a number of obstacles, and have one tremendous advantage.

Systematic study of the experiences of economies in transition suggests that specific circumstances play a large role in determining relative success in post-socialist transitions. To the extent that there are systematic determinants of these outcomes they relate to the exent of macroeconomic stability when reform is commenced, the structure of output, and the existence of pre-socialist commercial legal traditions. North Korea does not appear to be particularly well-placed on these criteria.⁶

The first challenge relates to North Korea's composition of output. 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. Needless to say, I believe that this view is gravely mistaken in that it conflates the abruptness with which reform measures are introduced with underlying structural factors.

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 1, 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.) In essence, this is the Lewis two-sector model of development under conditions of surplus agricultural labor in action.

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 recent defeat of the Kuomintang candidate for the presidency, no 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, as the son will in effect, have to disavow the policies of the father.⁷

Balanced against these challenges is one great advantage that other transitional economies have not had-namely the existence of a benefactor in the form of South Korea.

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.⁸ 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.⁹ 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, the Bank of Korea (BOK). The 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 summit, figures were released indicating that the North Korean economy had grown by 6.2 percent in 1999 (Table 2). This was surprising inasmuch as that multiple sources had estimated that the volume of North Korea's international trade-probably the most accurate externally observable measure of the state of the North Korean economy-declined in 1999 (with the notable exception of North-South processing on commission trade). The BOK announcement was greeted with universal disbelief by economists working outside the South Korean government.¹⁰

There are at least five possible explanations for the apparent divergence between the expectations of professional observers and the BOK's numbers. One that was plausible in the spring, 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.¹¹ The problem, of course, is that the figures in Table 2, 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 food 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 discountinuous movement in the series. Put differently, if this explanation is correct, then ceteris paribus one would expect that next year's growth figure to fall into 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 different value-added weights were used to construct the figures for 1999.

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 got 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. By 1999, the North Koreans were signaling that enhancing supplies of energy, not food, was their top priority. 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 was claimed would permit them to attain minimum human needs self-sufficiency by 2002. 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, which would both facilitate the importation of inputs such as fertilizers and pesticides and allow the North Koreans to cover unexpected short-falls on commercial terms.¹² Second, frustrated by lack of access and North Korean dissembling, a number of nongovernmental organizations 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 frayed. Of course, the puzzle remains, if the North Korean economy experienced sustainable industrial growth of more than 6 percent last year, why would they need $250 million in grant assistance?

Perhaps the answer to this question lies in the past behavior of the North Korean government and its counterparts. In the recent past, Pyongyang has pursued essentially two coping strategies, one-off projects to generate foreign exchange and extortion. The October 1998 agreement between Hyundai and Pyongyang is important in this regard. First, payments committed to by Hyundai dwarf anything that North Korea could plausibly earn in Rajin-Sonbong, and second the Hyundai agreement extends the possibility of the construction of a new SEZ.

Hyundai has guaranteed North Korea $942 million over 75 months, with the payment schedule front-loaded for the first six months. (Indeed, the North Koreans used brinkmanship to extract up-front payments before the first tour visited Mt. Kumgang in November 1998.) At $300 per passenger, North Korea stands to make $450 million per year off the tourism agreement alone in the admittedly unlikely case that Hyundai is able to reach its target of 1.5 million visitors per year in 2005. To put this in perspective, this money, if properly deployed, would be enough to permit North Korea to cover its food gap on commercial terms. Unfortunately, it is believed that the funds are going into the Macau bank account of "Bureau 39," a party organization controlled by Kim Jong-il, to be used for "regime maintenance." If this is how the Mt. Kumgang tourism project plays out, it will amount to a successful version of what Rajin-Sonbong is not-a regime-preserving hard currency earner with no real systemic implications for the organization of the North Korean economy or society.

In this respect, the rest of the Hyundai deal might be more significant. The agreement also calls for the development of an industrial part, which will apparently be located in Kaesong. This appears to have far greater prospects than Rajin-Sonbong. First, the geographical location is far more auspicious. Second, it has the backing of Hyundai (and presumably the South Korean government). This is critical both from the standpoint that it provides the necessary infrastructure (which Rajin-Sonbong sorely lacks) and carries the imprimatur of Hyundai (and by extension the South Korean government). Thus, South Korean small- and medium-sized enterprises are far more likely to move light manufacturing operations to Kaesong than Rajin-Sonbong.

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.

Getting from here to there

All this is to say that successful consensual unification would require a significant reorientation of North Korean policy. 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, and counterfeiting. 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 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.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 no more interruptions in service, the Hyundai 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, 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.

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.¹⁵ 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 United States playing smaller roles-even with the United States partially lifting its embargo against North Korea in June 2000.¹⁶ Thus the necessary recurrent external financing needs would be around $1 billion annually.

Where could this money come from? The South Korean government has established an economic cooperation fund, but the resources are inadequate to address the North's pressing 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 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.¹⁷ 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 $1 billion 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 United States, 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 has 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.¹⁸ 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 United States 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.¹⁹ 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 United States, Japan, South Korea and others set up a special fund for North Korea at the World Bank or ADB.²⁰ 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.²¹ 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. Bank staff has 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.

These developments might be thought of as the necessary, though not sufficient, conditions for consensual unification. Even if they were to occur they would only get the two Koreas part way down the road. Moreover, these developments do not necessarily imply progress toward consensual unification. North Korea could adopt the minimalist reform program and reject unification overtures from the South. Indeed, while implementing such a program, the North might feel compelled to limit discussion of unification precisely to prevent system overload and a loss of control.

Conclusions

How this all plays out, indeed whether national reconciliation along the lines examined in this paper is likely, depends, at least in part, on the intentions of the North Korean elite. A necessary condition for consensual unification would be a willingness of this elite to countenance a certain degree of reform of current practices. 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.

It would be that North Korea intends, essentially, to adopt the techniques of economic reform without adhering to either the ethos of the market economy or to the dominant values embodied in the international system. In this case the United States and South Korea could be confronted with a strengthened adversary on the Korean peninsula.

How can we tell? Despite the reported stabilization of the economy (or even its revival if the BOK is to be believed), and enhanced 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 to 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, in the past year there is reason for unease. According to the South Korean National Defense White Paper (1999), North Korea has 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.

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 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 in 1996 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.²²

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 may convey positive externalities to South Korea and the social rate of return on South Korean investment in the North may 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 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.²³

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 one, 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 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 bottomline is that South Korea has been traumatized by its financial crisis. Although the economy is currently experiencing a cyclical recovery from the depths of 1998, the July 2000 bank strike and the ongoing travails of Hyundai are reminders that the country has not put the financial crisis completely behind it. Hopefully, the crisis has dealt the process of constructive disengagment of the state from the economy only a temporary set-back. The continuance of structural reform and constructive disengagement would be a difficult process for any country under any circumstance. The existence of the North adds a tremendous additional layer of complexity to the challenge that South Korea now encounters.

Yet North Korea faces a fundamentally supportive international environment. South Korea, Japan, China, even the United States 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 series of ad hoc adjustments while supported by external powers which would prefer to see a less belligerent North Korea muddle along to the risks of instability or collapse.²⁴ 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.²⁵

Table 1: Percentage distribution of labor force at time of reform

Table 2: North Korean Growth, 1999

References

Cheong, Kwang-soo and C.H. Lee. 1996. "Toward Korean Unification: A Policy Proposal for Investment in North Korea," University of Hawaii at Manoa, January, processed.

Eberstadt, Nicholas. 1995. Korea Approaches Reunification. Armonk, NY: ME Sharpe.

Eberstadt, Nicholas. 1998. "North Korea's Unification Policy: 1948-1996," in Samuel S. Kim editor, North Korean Foreign Relations, Oxford: Oxford University Press.

Eberstadt, Nicholas. 2000. "Deciphering North Korea's Economy," Asian Wall Street Journal, 28 September.

Food and Agricultural Organization. 2000. "Special Report: FAO/WFP Crop and Food Supply Assessment Mission to the Democratic People's Republic of Korea," Rome, 24 July.

Gertz, Bill. 1999. Betrayal. Washington: Regnery Publishing.

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Hong, Soon-jick. 2000. "North Korea's Infrastructure Conditions and Strategies for Investment," VIP Report, Hyundai Research Institute, July.

Huntington, Samuel P. 1968. Political Order in Changing Societies. New Haven: Yale University Press.

Kim, Choong-nam. 2000. "Pyongyang's Dilemma of Reform and Opening: How to Compromise Economic Benefits with Political Risks," Korea and World Affairs, 24:2 247-276.

Manyin, Mark E. 2000. "North Korea-Japan Relations: The Normalization Talks and the Compensation/Reparations Issue," CRS Report for Congress, Washington: Congressional Research Service, 21 April.

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Noland, Marcus, Sherman Robinson, and LiGang Liu. 1999. The Economics of Korean Unification. Journal of Policy Reform 3: 255-99.

Noland, Marcus, Sherman Robinson, and Monica Scatasta. 1997. "Modeling North Korean Economic Reform," Journal of Asian Economics, 8:1 15-38.

Noland, Marcus, Sherman Robinson, and Tao Wang. 2000a. "Rigorous Speculation: The Collapse and Revival of the North Korean Economy," World Development, forthcoming (September).

Noland, Marcus, Sherman Robinson, and Tao Wang. 2000b. "Famine In North Korea: Causes and Cures," Economic Development and Cultural Change, forthcoming.

Noland, Marcus, Sherman Robinson, and Tao Wang. 2000c. "Modeling Korean Unification," Journal of Comparative Economics, (June).

Oberdorfer, Don. 1997. The Two Koreas. Reading: Addison-Wesley.

Park, Han-shik. 1993. "North Korea's Ideology and Unification Policy," in Jay Speakman and Chae-Jin Lee editors, The Prospects for Korean Unification. Claremont, CA: Keck Center for International and Strategic Studies.

Von Hippel, David and Peter Hayes. 1998. "DPRK Energy Sector: Current Status and Scenarios for 2000 and 2005," in Marcus Noland editor, Economic Integration of the Korean Peninsula, Special Report 10, Washington: Institute for International Economics.

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.

Yu, Suk-ryul. 1997. "Problems for Korean Reunification," paper presented at the Joint Conference of the Council for U.S.-Korean Security Studies and the International Council On Korean Studies, Arlington VA, 23-4 October.

Notes

1. These events are described in greater detail in Noland (2000).

2. For details of this proposal, see Han and Choe (1995) and Yu (1997). For highly informative interpretations of North Korea's unification policy see H.S. Park (1993) and Eberstadt (1998).

3. Discussions have reportedly already begun with respect to clearing mines from the demilitarized zone (DMZ) in order to establish the rail links. It has also been reported that at the Okinawa G8 summit, Russian President Vladimir Putin asked Japanese Prime Minister Mori to cooperate on the east coast rail line, which could link Russia and South Korea.

4. See Noland (2000) for specific references to these formulations.

5. 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. At present, foreigners, though not Japanese, are permitted to join the Hyundai tour, although a Japanese newspaper has reported that plans are in the works to permit limited visits by Japanese.

6. See Noland (2000) chapter 7 for a more extensive treatment of this issue, and citations to the relevant literature.

7. 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 one view or another that will conveniently support the policy that Kim fils wishes to pursue.

8. See Noland (2000) chapter 3 for a discussion of the hazards of estimating North Korean national income and a summary of alternative estimates.

9. See Noland (2000) chapter 5 for a discussion of the famine.

10. See, for example, Oxford Analytica, 9 May 2000 and Eberstadt (2000). One explanation for the timing of the BOK announcement is that its statisticians had undertaken a rebasing of base years and this contributed to a delay in releasing their estimate.

11. 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 existent estimates, it would have concluded that there had been no economic growth at all in North Korea in 1999.

12. 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 by 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.

13. On the first point, see Noland (1996, 2000). For detailed analyses pertaining to the second point, see Noland, Robinson, and Scatasta (1997), and Noland, Robinson, and Wang (2000a).

14. See Von Hippel and Hayes (1998).

15. One should be careful about drawing too simple a causal link between material conditions and political change. There is no theory that reliably maps deprivation to political change. Indeed, in his classic study of political change, Huntington (1968) argues that political change more often occurs in the context of material gains and rising expectations than stagnation. In particular, to the extent that political change has accompanied famine, it has usually occurred after famine episodes when conditions have sufficiently stabilized for responsibility to be assigned and blame to be assessed. During famines, populations are typically too focused on survival to engage in political activities. However, in the case of North Korea, Gertz (1999) reproduces a secret State Department cable that refers to "extensive evidence of a major coup attempt by elements of the VI Corps in 1995, which appears to have been crushed only with some difficulty" (p. 264). The State Department has not denied the authenticity of this cable. According to Oberdorfer (1997) after the uprising the corps, based in the famine-stricken northeastern city of Hamhung, "was disbanded, its leadership purged, and its units submerged into others under circumstances suggesting disarray in the ranks" (p.375).

16. This assumes that liberalization in the North was on a non-preferential basis. As shown in Noland, Robinson, and Liu (1999) and Noland, Robinson, and Wang (2000c), the formation of a customs union between North Korea and South Korea would have a big impact on the North while it would have a trivial impact on the South. The customs union would represent a major trade liberalization on the part of the North, while the North's economy would be too small to have much of an impact on the South's economy. (Think of the impact of NAFTA on the United States or the accession of a small central European economy on the European Union.) This story-big impact on the North, small impact on the South-would change considerably if integration were to come through collapse, as discussed in the next section.

17. See Manyin (2000) for alternative estimates and additional discussion of compensation issues.

18. 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 "our position on membership is unchanged. Both because our own legislation requires us to do so [and] because North Korea is an international terrorist state…as 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).

19. World Bank President James Wolfensohn already signaled as much, writing in a July 2000 letter to South Korean President Kim Dae-jung that "We 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." The North Koreans were invited to the September 2000 joint World Bank-IMF annual meetings in Prague, but declined to attend.

20. The ideas of a Northeast Asia fund or a Northeast Asia Development Bank have also been mooted.

21. 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).

22. A good example of this would be Hyundai's Mt. Kumgang tourism project, which, according to South Korean press reports is losing more than $100 million annually. The fear, 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. For example I was afraid that the government would be tempted to steer Daewoo Motors to Hyundai (effectively giving Hyundai a monopoly on the South Korean passenger car market) as a kind of reward for its activities in the North. It is a good sign that this appears unlikely to occur.

23. See Cheong and Lee (1996) for such a proposal. It should be noted however, that Kim Dae-jung has expressed the opposite concern, namely that a "gold rush" mentality may generate excess investment in the North, and has floated the idea of some kind of government coordination. In addition to coordinating investment in the North, this approach could facilitate state meddling in the South Korean economy.

24. See Kim (2000) for a similar conception of a "limited reform strategy."

25. See Noland (2000) chapter 9 for further elaboration on this theme, and a comparison to the Romanian case.