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North Korea: Witness to Transformation

Change We Can’t Believe In: Haggard at Foreign Policy on the Prospects for Economic Reform

by | April 8th, 2013 | 12:16 pm
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The North Koreans have now moved their effort to show resolve to Kaesong. Tomorrow, we will look at recent events there more closely, but they seem to us like a perfect example of shooting yourself in the foot. Today at Foreign Policy, I complement Marc Noland’s interview by asking whether the effort to combine the nuclear program with economic reform is plausible. My conclusion: “good luck with that.” In another piece at Foreign Policy from almost exactly a year ago (Could North Korea Have Struck it Rich?), I rerun the historical record and ask what it would have taken for North Korea to join the Asian economic miracle. My conclusion: it would have been easier than you think.

Change We Can’t Believe In

At a meeting this week of the Supreme People’s Assembly, North Korea’s version of a legislature, the leadership promoted Pak Pong Ju to the position of premier, once again stirring speculation that it is pondering much-needed economic reforms. Some pundits have speculated that Pak is the Korean face of reform; he was indeed premier during a period of modest economic policy changes in the early 2000s, before reform went into reverse and he was purged. And just like before, Pak heads the cabinet, the political body with the most immediate interest in economic policy.

But Pak’s appointment raises a series of questions. Can a country issuing nuclear threats and aggressively pursuing a missile program hang out a shingle that says “open for business”? Can North Korea suspend access to Kaesong, an industrial park run jointly with South Korea, and still claim to seek foreign investment? Will either domestic or foreign firms find any new policy measures Pak might institute credible? For the answer to any of these questions to be yes, the world will be looking for deeds, not just speculation.

The domestic political challenges to reform are the most fundamental issue, and unfortunately the least understood by outsiders. North Korea remains desperately poor; its per capita income is roughly on a par with Pakistan’s or the Ivory Coast’s. The World Food Program estimates that nearly a third of the country is vulnerable to malnutrition. There is a lot of work to do. To succeed, new economic policy measures must ultimately reallocate resources from the bloated military sector to more productive forms of investment, and increase household consumption.

This is no easy task, in part because the military is deeply intertwined with the party and state as a result of Kim Jong Il’s “military first” policy. Kim Jong Un and his backers have purged high-ranking military officers. But since succeeding his father in December 2011, the younger Kim has also promoted hundreds of officers, and brought dozens into the Politburo, Party Secretariat, National Defense Commission, and other key institutions. It’s unlikely Kim will be able to convince the military to launch reforms that weaken its influence. The military and security apparatus not only influence important policy decisions, but also run businesses that enrich high-ranking officers and their networks. In late March, Kim was shown visiting a military unit that made playground equipment and musical instruments. Are these units going to give up their businesses and operate in a more competitive environment?

For North Korea, the central economic questions center on the relationship between the government, state-owned enterprises, and the private sector. Reform means giving managers more discretion and allowing greater freedom for private actors to invest, hire, and make money. Is the regime OK with an emergent capitalist class? The Chinese lived with it, and if the reforms extend only to their cronies, the regime may be adequately comfortable. Half-baked reforms are better than nothing. But they are also difficult to fix later, as both Russia and China are now learning.

History suggests that North Korean leaders have little tolerance for unleashing market forces. The regime ultimately backpedaled from its 2002 reforms: It opened markets, only to harass and close them when it became uncomfortable withthe emergence of potentially powerful private traders. In 2009, in the mother of all policy mistakes, the regime undertook a massive forced currency conversion that wiped out the working capital of major traders (or at least those without inside information). With markets closed, the country experienced hyperinflation as traders and households fled the domestic currency and hoarded commodities.

Surveys Marcus Noland of the Peterson Institute of International Economics and I conducted on Chinese firms doing business in North Korea reveal a pattern that almost certainly also pertains to the domestic market. Two types of Chinese firms succeed in North Korea: those that are large and protected by political connections, and those that are small and can fly under the radar. While this combination is better than having only a sclerotic public sector, the scope for growth is limited at the outset.

In the meetings that took place earlier this week, the North Korean leadership outlined a new  strategic course: seek to develop nuclear weapons and space technology — a euphemism for a long-range missile program — while at the same time focusing on economic reconstruction. But North Korea is a small economy and reforms are unlikely to succeed unlessthey attract foreign capital, technology, and management.

Who has the nerve to wade into such a setting? The country is now under a complex sanctions regime. The new financial sanctions are only supposed to apply to transactions related to the country’s weapons of mass destruction and missile programs. But in an economy where everything is ultimately under government control, it is hard to draw such fine lines and many firms won’t risk investing at all.

Potential investors will note that the recent cycle of escalatory rhetoric began in February, while the U.N. Security Council was negotiating a new sanctions resolution. These sanctions will likely be more effective than previous rounds, and the Chinese appear to be putting some restraints on North Korean banks. No matter how well-intentioned North Korean policy statements of economic openness may appear, they are easily reversible. North Korea is — unsurprisingly — a difficult place for foreign companies to do business. Even Chinese firms have been embroiled in debilitating investment disputes.

A crucial indicator with respect to North Korean intent — and the likely foreign response — is the Kaesong Industrial Complex; consider it a leading indicator of North Korean credibility. On Wednesday, the North Koreans appeared to toy with shutting the complex down. The largest export-processing zone in the country—raking in about $90 million a year for North Korea–has been turned into a political football. Shutting it down would be a major annoyance for the more than 120 South Korean firms, reliant on cheap labor, that operate there. But for North Korea, the consequences will be much worse. This may explain the regime’s caution.

Why should foreign firms bother when so many other locations are welcoming and supportive of foreign investors? Only a few types of firms appear willing to risk it. North Korea’s reserves of natural resources are attractive,  and large Chinese firms have signed contracts that are effectively guaranteed by the flow of commodities. A second group of firms are those from countries that are unlikely to take a particularly close look at U.N. sanctions resolutions and lack the complex export and financial control mechanisms (for example, the Egyptian telecommunications firm Orascom, which helped build North Korea’s cellular network). Smaller, labor-intensive Chinese firms appear to be doing business, and some South Korean firms have invested in Kaesong, where they are effectively protected by insurance and a kind of mutual hostage game in which both sides are willing to leave the zone open.

But this excludes Japan, Russia, Western Europe, the United States, most South Korean firms, and a large swath of potential investment from other middle-income countries in the region such as Malaysia, Taiwan, or Thailand. The cast of residual characters raises other risks for the North Korean leadership, most notably whether it wants to be an economic colony of China.

In Shakespeare’s play Henry IV Part I, a prince claims that he can summon spirits from the “vasty deep,” to which a soldier retorts “Why, so can I, or so can any man; but will they come when you do call for them?” Put another way, economic reform and growth are not a function of hortatory statements and proclamations of grandiose intent. Reforms should ultimately elicit investment and effort. There is no evidence of a stampede to North Korea’s door.

North Korea does not need to become laissez-faire Hong Kong in order to prosper; it can undertake reforms with its own characteristics, as China did. Indeed, given how distorted the economy is, even modest reforms will yield gains. My fingers remain firmly crossed. But the regime does not seem to appreciate the contradiction in maintaining a huge, threatening military presence while at the same time seeking to assure market actors that the water is fine and they should dive in.