Some Unpleasant Arithmetic Concerning Unification

Paper prepared for the Eleventh Annual Conference of the Council on US-Korean Security Studies, Seoul, Korea, October 23-25, 1996. I would like to thank Li-Gang Liu for research assistance, and John Bennett, Gary Hufbauer, and John Williamson for helpful comments on an earlier draft.

Abstract

Barring a second war on the Korean peninsula, Korean economic integration will occur, be it through successful economic reform and opening in the North, collapse and absorption along the lines of the German case, or a period of "muddling through" in which the North Korean government makes hesitant and insufficient economic reforms, and the South is drawn into supporting the North economically to stave off collapse. Whatever the mechanism, certain processes of economic integration such as increased integration of product markets, and the movement of labor-intensive light manufacturing industries from the South to North, are likely to occur regardless of the political specifics of reunification.

Moreover, the divergence of economic conditions between the North and South has grown so wide, that the costs of unification, defined as the capital investment in North Korea necessary to raise incomes in the North to a sufficiently high level to choke off mass migration to the South, are so large as to be improbably attained. As a consequence, even under optimistic scenarios, there will be enormous economic incentives for North Koreans to move South.

This has important implications for current South Korean domestic policy, regardless of the specific political modality under which economic integration occurs. The imperative for South Korean policy will be to minimize the burdens imposed on South Korean taxpayers by the exigency of financing the economic reconstruction of the North. This requires policies to encourage foreign capital, specifically foreign private capital, to flow into North and South Korea. Specifically, South Korea needs to continue to improve its foreign direct investment regime, as well as encourage the development of efficient domestic bond markets of all maturities which can be used to mobilize large sums of capital when the need arises. Creating this capacity to mobilize global private capital quickly will be particularly important if economic integration occurs through Northern collapse and the extension of South Korean laws and institutions throughout the unified Korea.

Introduction

Korean economic integration will occur, be it through successful economic reform and opening in the North, collapse and absorption along the lines of the German case, or a period of "muddling through" in which the North Korean government makes hesitant and insufficient economic reforms, and the South is drawn into supporting the North economically to stave off collapse. These alternatives are neither exhaustive nor exclusive: one can imagine for example, a prolonged period of muddling through prior to collapse as the final denouement of the North Korean regime. The point is simply that whatever the mechanism, certain processes of economic integration such as increased integration of product markets, and the movement of labor-intensive light manufacturing industries from the South to North, are likely to occur regardless of the political specifics of reunification.(1) The only alternative that could lead to a fundamentally different economic outcome would be a second Korean War which could leave both countries economically devastated. For the purposes of this paper, this last, and presumably low probability, alternative will be set aside to focus on the implications of the more likely one: increased North-South economic integration.

In a nutshell, the divergence of economic conditions between the North and South has grown so wide, that the costs of unification, defined as the capital investment in North Korea necessary to raise incomes in the North to a sufficiently high level to choke off mass migration to the South, are so large as to be improbably attained. As a consequence, even under optimistic scenarios, there will be enormous economic incentives for North Koreans to move South, and the potential for such migration is enormous: assuming that a person carrying some belongings could travel 20 miles a day, 40 percent of the population of North Korea lives within in a 5 day walk of the DMZ. Seoul for all intents and purposes would be a beacon. How this eventually works itself out will be determined by specific conditions, most importantly whether economic integration is accompanied by political unification. Generically speaking, there are two things South Korea can do to discourage migration: maintain the existing demilitarized zone as a method of controlling population influx, and encourage capital investment in the North to lessen the incentive to emigrate.

While the former option is fraught with political difficulties, the complementary alternative has important implications for current South Korean domestic policy, regardless of the specific political modality under which economic integration occurs. The imperative for South Korean policy will be to minimize the burdens imposed on South Korean taxpayers by the exigency of financing the economic reconstruction of the North. This requires policies to encourage foreign capital, specifically foreign private capital, to flow into North and South Korea. Specifically, South Korea needs to continue to improve its foreign direct investment regime, as well as encourage the development of efficient domestic bond markets of all maturities which can be used to mobilize large sums of capital when the need arises. Creating this capacity to mobilize global private capital quickly will be particularly important if economic integration is accompanied by political integration, and the extension of South Korean laws and institutions throughout the unified Korea.

Costs of Unification

Noland, Robinson, and Scatasta (1996) report the results of a computable general equilibrium (CGE) model of the North Korean economy, apparently the only behavioral model (as opposed to accounting representation) of the North Korean economy existent.(2) According to the results of this model, the North Korean economy is extraordinarily distorted, and the economy could potentially experience increases in output, on the order of 50 percent, if more rational economic policies were adopted. Even such dramatic increases in income would leave incomes in the North far below those in the South. According to estimates reported in Noland (1996a) properly measured per capita incomes in South Korea were nearly four times those in North Korea in 1990.(3) The gap has widened in the intervening years, and by 1995, South Korean incomes were something on the order of seven times those in the North. If this trend continues, by the year 2000 South Korean per capita incomes will be twelve times as large as those in the North, and even a 50 percent increase in Northern incomes through the adoption of economically rational policies would leave an enormous gap. Under such circumstances residents of the North would experience tremendous incentives to move South, and the relatively young structure of the North's population demographics would facilitate just this sort of exodus. If labor markets were permitted to integrate, millions of North Koreans would head South.

Under such circumstances the South could pursue a two-track policy: control its borders to discourage entry, while at the same time trying to increase the economic attractiveness of North Korea in order to discourage emigration. The former track could be fraught with political difficulties and would likely prove to be politically disruptive in the South: one need only contemplate the specter of the armed forces of a democratically elected South Korean government firing on North Korean refugees, or alternatively herding them into prison-like refugee camps. Indeed, incumbent elected officials in the South, counting votes, might regard Northerners as a potential one-third of the electorate in a unified state, and tend toward a policy of treating them gently, if not generously. So while the DMZ may provide South Korean authorities some short-run room to maneuver in dealing with potential migration problems, it is neither a foolproof or permanent solution to problems of population control.

This means that ultimately South Korean policy will focus on increasing the desirability of residence in North Korea. The German case is instructive in this regard. Survey data from the former East Germany reported in Dornbusch and Wolf (1994) indicate that willingness to migrate was driven first by fears of unemployment, second by environmental concerns, and only third by wage differentials. Home ownership was found to be robustly negatively correlated with willingness to move. So policies to maintain employment and encourage private ownership of housing (which is practically non-existent in North Korea today) would appear key to discouraging southward migration.(4) Although the elasticity of migration with respect to wage differentials is clearly non-zero, it would not appear to be necessary to equalize North and South Korean per capita incomes to prevent mass migration: the per capita income of the poorest region of South Korea is only 60 percent of the richest area, and the simple average provincial income is only 76 percent that of the richest. Within West Germany, wage differentials of 70 percent exist without inducing large scale migration. In the United States, the poorest state has income per capita only around half as great as the richest. Presumably a united Korea could exist with substantial per capita income differences without undue social strain.

The CGE model can be used to generate comparative static estimates of the amount of capital inflow necessary to raise North Korean per capita incomes to some target level. Several studies have adopted the 60 percent level as the level necessary to choke off mass migration. According to this model this would amount to roughly one half to three quarters of a trillion dollars if unification occurred in 1995, with the figure roughly doubling every five years as the income gap between North and South Korea widens.(5)

The obvious question is whether it is reasonable to expect capital inflows of this magnitude. Suppose the process of unification started in 1995 or 2000 and the cost was spread over ten years. (In this case, the ultimate amounts of capital transfers could be larger than those noted above, because if South Korea continued to grow during the catch-up phase, North Korea would be chasing a "moving target".) What would be the implied current account deficit of the unified Korea, and what would be the implicit growth rate of North Korea? Table 1 summarizes this mental experiment under three scenarios. In scenario A, the entire capital inflow comes from abroad, and South Korea maintains its current growth rate. In scenario B, $350 billion of capital (about one third of the ultimate cost) flows from South to North Korea, reducing the rate of investment in the South, and halving its growth rate. In scenario C, the South Korean transfers rise to a half trillion and South Korean growth ceases.

As shown in table 1, these scenarios imply implausibly rapid growth rates for North Korea accompanied by large current account deficits for a unified Korea. Even less plausible results are obtained in table 2, when the calculations are rebased to 2000.

An alternative thought experiment would be to ask if North Korea maintained its maximum plausible growth rate how long would it take to reach the income target (60 percent of South Korean per capita GDP). This is shown in scenario D, in which South Korea finances one-third of the cost of unification, and experiences a halving of its growth rate. If unification had begun in 1995, North Korea would have achieved the income target in 18 years, and the current account deficit would have averaged a still very large 8 percent of GDP. As the onset of unification is delayed, and the initial gap between North and South Korean incomes widen, the target recedes into the distance. Under current trends, if the start of unification were postponed until 2000, it would take North Korea a full generation to reach the goal. It seems highly unlikely that officials could keep the population of North Korea contained for this long. It appears then that Korea will be unable to absorb capital fast enough for a rapid convergence in incomes between the North and South.(6) The alternative is significant population movement from North to South.

Implications for Current South Korean Policy

South Korea could thus find itself desperately trying to mobilize domestic and foreign capital to stave off as much mass migration as possible.(7) Some international public capital should be available. To cite but one example, the World Bank maintains a special program for peace and sustainable development in the Occupied Territories in the Middle East. A similar program, scaled to the much larger North Korean population would imply World Bank investments of $4.4 billion annually.(8) Also, North Korea and Japan have yet to settle post-colonial claims. Taking the 1965 settlement between South Korea and Japan as a base, and adjusting for changes in the price level, differences in population, accrued interest etc. one obtains a figure on the order of $12 billion. However, the fund for the Occupied Territories may be sui generis, and given the current state of Japanese public finances it is unlikely that the North Koreans will be able to extract this sum from Japan. And even if public capital on this scale could be tapped, the amounts are still small relative to capital inflow required. In the end most of the capital for financing the economic reconstruction of North Korea will have to come from private sources.

This private capital inflow could take two forms: direct and portfolio investment. With respect to the former, historically South Korea has had a reputation for being relatively hostile to foreign investment. Policies have become more accommodating in the last several years and foreign direct investment has grown in response. South Korea should continue to create a more hospitable environment for foreign investors. In the case of South Korea, liberal policies toward foreign direct investment not only have the traditional benefits, but will facilitate capital inflow into unified Korea (or alternatively will encourage the inflow into South Korea of foreign capital to substitute for South Korean capital invested in the North prior to political unification).

With respect to portfolio investment, Korean financial markets are still heavily regulated and continue to discourage foreign participation in a variety of ways. The Korean government needs to develop a government bond market. There is absolutely no reason that prospective infrastructural investments in the North should be financed out of current tax receipts. It also needs to fully integrate foreign investors into both its bond and stock markets. Again, liberalization would provide a double benefit: both the traditional benefits in terms of increased efficiency of financial intermediation, as well as putting into place the necessary market infrastructure to mobilize large of amounts offoreign capital needed for the rebuilding of North Korea.(9)

Financial market liberalization has become a highly contentious issue in South Korea, and clearly policy makers should act with prudence and deliberation when implementing financial reforms. But if there is a single economic policy that the current government in Seoul could undertake in preparation of unification, it would be to strengthen and open its financial markets to promote the eventual economic rehabilitation of the North.(10)

Notes

1. Some of the specifics would obviously differ depending on the particulars of the situation. For example, if North Korea collapsed and was absorbed by South Korea, South Korean laws and institutions would replace those in the North, the South Korean won would replace the North Korean won, the South Korean government would presumably lose any inhibitions about South Korean firms investing in the North, trade in goods would occur directly and firms would not have recourse to international trade laws for protection, and so on. None of these would necessarily occur if the North Korean state continued to exist.

2. The model has a standard neoclassical specification, except that the model incorporates severe quantity controls in exports and imports, with concomitant distortions in domestic product and factor markets. The markets for goods, factors, and foreign exchange are assumed to respond to changing demand and supply conditions, which in turn are affected by government policies, the external environment, and other exogenous influences. The model can be considered medium-to-long run in that all factors are assumed to be intersectorally mobile. It is Walrasian in that only relative prices matter. Sectoral product prices, factor prices, and the exchange rate are determined relative to an aggregate consumer price index, which defines the numeraire. The model can be closed either by fixing the trade balance or the real exchange rate. In practice it made little difference which of these closures is imposed.

The model has eight sectors: agriculture/forest/fisheries, mining, light manufacturing, industrial intermediates, capital goods, construction, public administration, and services. There are three "demanders": a single aggregate household which buys consumer goods, government which spends on goods and public administration, and an aggregate capital account which purchases investment goods. Primary factors of production are capital, agricultural labor, high-skill urban labor, and low-skill urban labor. Land is not explicitly modeled as a separate factor and can be considered as subsumed in agricultural capital. Econometric estimation indicated that the hypothesis of an aggregate Cobb-Douglas production function could not be rejected. Sectoral production technology is represented by a set of Cobb- Douglas functions of the primary factors, while intermediate inputs are demanded according to Leontief, fixed input-output coefficients. See Noland, Robinson, and Scatasta (1996) for a complete description of the model.

3. These figures are "purchasing power adjusted" and imply a smaller gap in incomes between the North and South than the less preferable non-purchasing power adjusted figures released by the National Unification Board. See Noland (1996a) for a discussion of these issues.

4. Noland (1996b) contains an extensive discussion of these issues.

5. These figures are dependent on specific assumptions, most importantly a) the amount of total factor productivity increase associated with economic reform and opening, b) the extent to which capital would be used more efficiently in a marketized North Korea, and c) the economic value of the existing North Korean capital stock after the economy was opened to international trade. The range of estimates in the text is based on alternative assumptions about these issues. These figures are generally in line with others produced using different methodologies (see Noland, Robinson, and Scatasta 1996, table 5).

6. This statement is based on the purely mechanical assumptions embodied in tables 1 and 2. A separate and important issue is the capacity of the both North Korean and foreign investors to identify and implement the actual projects which would be financed by these inflows. This is probably a serious constraint on absorptive capacity.

7. See Noland (1996b) for a more complete description of the economic costs and benefits of unification.

8. It has been argued, however, that an independent and poor North Korea would receive better treatment from the international lending agencies than a unified middle income Korea.

9. South Korea may also have to consider reforms to increase the efficiency of tax collection, and a more aggressive policy of privatization and selling off government assets to raise unification funds.

10. See Noland (1996c) for a detailed discussion of these issues.

References

Dornbusch, Rudiger, and Holger C. Wolf. 1994. East German Economic Reconstruction." In Olivier Jean Blanchard, Kenneth A. Froot, and Jeffrey D. Sachs, The Transition in Eastern Europe, vol. 1. Chicago: University of Chicago Press, 155-190.

Noland, Marcus. 1996a. "The North Korean Economy." Joint US - Korea Academic Studies 6: 127-78.

Noland, Marcus. 1996b. German Lessons for Korea: The Economics of Unification. Asia-Pacific Working Paper Series 96-3. Washington: Institute for International Economics.

Noland, Marcus. 1996c. "Restructuring Korea's Financial Sector for Greater Competitiveness." Washington: Institute for International Economics, processed.

Noland, Marcus, Sherman Robinson, and Monica Scatasta. 1996. "Modeling Economic Reform in North Korea." Journal of Asian Economics, forthcoming; Asia-Pacific Working Paper Series 96-10. Washington: Institute for International Economics.

Table 1: Unification Scenarios, 1995 Base

a. total capital transfers are not equal across scenarios because the value of South Korean income (and hence North Korean target income) differ at the end of the catch-up period.

Table 2: Unification Scenarios, 2000 Base

a. total capital transfers are not equal across scenarios because the value of South Korean income (and hence North Korean target income) differ at the end of the catch-up period.