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North Korea: Witness to Transformation

Build It and They Will Come

by | November 12th, 2013 | 07:09 am
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A couple of weeks ago, an international conference in Pyongyang followed by press reports that North Korea was planning 14 additional SEZs set off the usual breathless “reform-is-around-the-corner” commentary. So, is it different this time? The smoke is never-ending, but is there actually a fire?

To start, a little historical perspective. Many, many countries have experimented with SEZs and similar initiatives, so there is a large corpus of historical data to form expectations. The World Bank recently completed a review of the uneven history of SEZs around the world. The report, by Thomas Farole, puts the North Korean developments in broader perspective and is worth quoting:

“First, it is important to separate political support from political objectives in zone projects. While strong commitment from government is needed, projects must be carefully designed based on clear strategic plans—the commercial case must be there. Moreover, that commercial case must be based on sustainable sources of competitiveness. Second, despite the concept of zones as enclaves, in practice their success is almost fully entwined with the competitiveness of the national economy and the national investment environment….Third, putting in place a clear and transparent legal and regulatory framework codifies the program strategy and establishes the “rules of the game” for all stakeholders involved in the process, but de facto implementation is of equal importance. In many SEZs, the authority responsible for developing, promoting, and regulating the program lacks resources and capacity as well as the institutional authority to carry out its mandate.”

The most successful SEZs are catalysts for change in the broader economy. One can identify two channels: real economic spillovers and policy effects.

With respect to spillovers, in the most narrow sense, do the zones generate what economists call backwards and forwards linkages? Do local firms become suppliers of inputs to foreign firms operating in the zone? Are the products produced in the zone used in the broader economy by local businesses or consumers? Does technology, broadly defined to include new management approaches or ways of doing business, diffuse beyond the confines of the SEZ?

And in terms of policy, do SEZs come to drive broader economic policy as in China in the 1980s? Are the more liberal rules in the SEZs eventually broadened to the whole economy?

Put bluntly, on these criteria, most SEZs fail. They don’t generate much investor interest nor, critically, do they act as a catalyst for changes in the broader economy. So with these diminished expectations, what about the specifics of the North Korean case?

The North Korean experience with SEZs has not been particularly successful. Rason has stumbled along for decades, and it is only after a long-gestating process of Chinese investment in the region have things begun looking up. The Hwanggumpyong and Wihwa Islands project remains just that—a project. And the most prominent of the initiatives, the KIC, underpinned by massive South Korean subsidies and other forms of public policy support, is an enclave with no backwards or forwards linkages, and apparently no significant demonstration effects.

Nevertheless, North Korea is so far down— having the world’s worst economic policy, if World Bank data is to be believed—that nearly any kind of movement on economic policy has to be regarded as a positive signal. But we should not overhype this latest development.

According to the Asahi Shimbun, North Korea will establish 14 new SEZs. Correspondent Akihiko Kaise writes that:

The list consists of four economic development zones, which cover trade, tourism and other sectors, three industrial development zones and two zones each for agricultural development, tourism development and export processing. In addition, a 14th zone for high-tech development has been created in Kaesong, on the border with South Korea. An industrial development zone in Wiwon, Jagang province, would combine mineral resources processing, machinery manufacturing and research on silk culture and freshwater fish farming…A tourism development zone in Onsong, North Hamgyong province, would feature a golf course, a swimming pool, a racetrack and accommodations. The proposal to companies said foreigners will have access to professional leisure and sightseeing services.”

But the Asahi Shimbun claims that on the basis of a proposal to potential investors obtained by the paper that most will be quite small—four square kilometers or less—making them more like “bonded warehouses” than SEZs as commonly understood. As a point of comparison the KIC is 66 square kilometers and the Hwanggumpyong and Wihwa zone is slated to be 23 square kilometers. So these are really mini- or micro-SEZs. Reputedly the whole initiative is being organized by the State Economic Development Committee, a supra-ministerial body established earlier this year, while KIC remains under another group. The big attractions are supposed to be a 14 percent tax rate and 50 year use-right for land. “In most new zones, foreigners will be able to set up businesses on their own,” Kaise writes.

Their size alone is not a positive signal, though if successful they can be expanded, so size is not dis-positive, at least in the beginning. The more critical point that many North Korea watchers miss is that the country does not exist in a vacuum. Why would a firm locate in one of these North Korean start-up SEZs rather than, say, Vietnam? Or rather than one of the dozen or so industrial zones being established in Myanmar, the current flavor of the month? Or Jordan, where investors get duty-free access to the US market, not the Smoot-Hawley tariffs goods from North Korea face? Or if one wants to go even further afield, the industrial zones that the Chinese are building in Zambia, for instance? Investors have plenty of opportunities around the world, so why would they go to North Korea? What is the competitive advantage of these start-ups? What sets North Korea apart and makes it a compelling location for economic activity?

In making that case, North Korea faces enormous challenges.

First, opacity. People investing real money (as opposed to writing op-eds) really want to know basic information about the business environment of the country before making irreversible commitments. Whether or not North Korea literally has the world’s worst economic policy, its terrible showing on the World Bank indicators is prima facie evidence of just how bad its reputation is.

Second, infrastructure, and most importantly power. Investors in industrial enterprises demand reliable power supplies. Again, North Korea faces significant challenges on this front.

Third, KIC. It cannot be overemphasized how terrible a blow the closure of KIC—the most prominent North Korean SEZ—has been to North Korean credibility. News stories that South Korean firms are now exiting KIC can’t help. And just to underscore the previous point that North Korean behavior cannot be evaluated in a vacuum, Vietnam is not abruptly closing its zones and expelling foreigners.  Neither is Cambodia, Jordan, Myanmar, Zambia, or any other country I can think of. The current Egyptian government is trying to reassure investors, not trying to bankrupt them.

Which leads to the final and most fundamental challenge: the byunjin line of parallel development of nuclear weapons and economic development. One recent commentator mentioned that problems obtaining risk insurance could deter investors. I could only think of that old beer commercial with the footage from a Jim Mora post-game press conference after a Saints loss where, in response to a reporter’s question regarding post-season possibilities, he repeats “Playoffs!? PLAYOFFS!?” with utter incredulity. Political risk insurance!? The Kim Jong-un regime has managed to raise a fundamental contradiction to the level of doctrine. It is going to be difficult to attract foreign investors to new SEZs—mini-, maxi- or otherwise—if a country is under ever-tightening international sanctions.

For the sake of the North Korean people, I wish them well.