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North Korea: Witness to Transformation

Kaesong Blues

by | April 10th, 2013 | 07:00 am
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In any contest of resolve, weaker parties seek to show they can bear costs. If that signal was missed by anyone over the last several weeks, Kim Jong Un has just delivered it again. A statement by Kim Yang Gon, secretary of the Central Committee of the Workers’ Party of Korea, announced the withdrawal of all North Korean workers from the zone and the temporary suspension of its operations.

Weaker parties also like to shift responsibility onto their adversaries; the North Koreans are past masters of creating messes that we are expected to clean up. Kim concluded his statement by noting that “how the situation will develop in the days ahead will entirely depend on the attitude of the south Korean authorities.” By shutting down the zone, North Korea has created a domestic lobby of 123 small- and medium-sized firms that will be desperate for a resolution.

The problem is broader, however; the real game is to shift wider market sentiment against the South.  In that regard, nothing could be more unfortunate than public comments about contingency plans to shift operations out of South Korea such as those made by GM CEO Dan Akerson this week.  Apparently a move in a bargaining game with South Korean unions, Akerson’s short-sighted comments played straight into North Korean hands. Picking up on the inviting prospect of panic, the Korean Asia-Pacific Peace Committee (조선아태평화위원) issued a warning that all foreigners in South Korea should make escape plans. Ever the gracious hosts, the statement goes on to say that the North does not want to see foreigners caught in the middle of a war.

Testing administrations at their outset is a North Korean trademark; President Obama got the treatment in 2009 and again now in his second term. Thankfully, President Park does not appear to be in a conciliatory mood. She publicly made arguments that we fully endorse as well:  that ”there will be no countries and companies left to invest in North Korea when it decides to break international rules and promises by halting operations at the KIC given how important predictability and trust are for investment.” We could not have said it better ourselves.

It could have been worse, we suppose. But an important risk has not yet fully passed. When the North Koreans started to play around with entry into the zone on April 3 (Korean time), there was concern for the safety of the 861 South Koreans and seven foreign workers staying at the complex full time. We were more concerned with limits on exit rather than limits on entry. The Ministry of National Defense legitimately issued a statement saying it had a contingency plan to remove workers if required to do so; this was one action that was explicitly mentioned by the North Koreans as “politicizing” the park. South Korean firms will now start to pull their managers out of the zone as well. But given the disposition of forces, there is no rescue operation for stranded Kaesong workers that will be simple. The North Koreans know that, so the risk of hostage-taking has be no means passed.

Prior to this move—which has a very different context and feel to it—the North Koreans have been relatively cautious. In 2008, Gen. Kim Yong-ch’ol, at that time in the National Defense Commission Planning Department, paid a visit to the zone and tried to signal its insignificance. He argued that the zone was a headache to the North—perhaps because of its strategic location—and asked pointedly how long it would take managers to shut it down. He was reined in, but later given command of the General Reconnaissance Bureau, suspected of involvement in the sinking of the Cheonan and other provocations around the Northern Limit line. In 2009, movement into and out of the zone was temporarily slowed at the time of Foal Eagle exercises as well. But in both cases, North Korea pulled back.  Pyongyang appears to be making it harder on itself to stand down this time around.

How will the costs be born? The zone yields the North about $90 million a year in wages, rents, fees and taxes, and in hard cash. There is not much information on the mechanics of these payments, perhaps because the process is so unseemly. But two pieces–a Chosun Ilbo report in 2006 and another from DailyNK last October—broadly align. According to the earlier Chosun Ilbo story, an armored cash transport truck leaves from the Woori Bank headquarters in Seoul to it’s branch office operating in the KIC once a month; at that time, estimated monthly cash deliveries were only $500 thousand per month. Once the Woori branch office received the cash, it was transferred to North Korean authorities in the form of the Central Special Development Guidance Bureau (중앙특구개발지도총국), which deducted lease payment, communication fees, registration fees, social security fees, etc. before the remaining amount was given out as wages. The DailyNK report cites a parliamentary audit on total payments from the onset of the zone in 2004 to July 2012 at $263.6 million.

Out of that total amount, wages took the largest share with $245.7 million, followed by the 50 year land lease of $12 million, communications fee of $4.8 million and resident registration fee of $975 thousand. Also, the report points out that South Korean companies have started to pay rtaxes since 2010, although the amounts are small.

But we don’t ultimately know what share of these wage payments actually end up in the hands of the workers in the complex; we review the issue here. We know that 45% of the wage bill–15% for “social security” and 30% for “socio-cultural policy entitlements”–flows into the regime’s coffer straight off the top, while the remaining 55% is supposedly given to the workers in either DPRK won or coupons. But the crucial issue is the exchange rate at which workers are paid and the value of the “coupons” they receive. We hardly need to state the obvious: North Korean workers are not getting paid the won equivalent of their dollar salaries at anything resembling the shadow-market exchange rate. Given the country’s high inflation and rapid depreciation of the exchange rate—see my colleague Marc Noland on this—the dollar value of what North Korean workers actually receive could be only a small fraction—even a very small fraction—of the stated dollar wage.

All of this is to say that the foregone revenue for the North is not trivial. The North Koreans are counting on the fact that the costs for the South will be even greater, and Seoul will therefore stand down and make some (still unclear) concessions.

What about the costs for the South? Total investment in the zone is estimated at about $840 million, with $350 of that in infrastructure and the remainder in the factories and equipment. This would presumably be written down if Kaesong were to go the way of the Mt. Kumgang resort and the closure made permanent (our posts on the Kumgang saga can be found here). But the costs would clearly be larger. Cho Bong-hyun, an economist at Industrial Bank of Korea (IBK), gave an estimate in 2009 that the economic damage caused by a KIC closure could go as high as 6 trillion won (~$ 5.5 billion) when taking bankruptcies of companies located into account. This seems high to us, but not utterly implausible.

But South Korea has one source of protection, and President Park has not hesitated to use it. Kaesong has always had an industrial policy component, providing assistance to labor-intensive manufacturing operations that would otherwise shut down or move offshore to China. To operate the zone, the government was constrained to set up an insurance scheme that would socialize losses; thanks to Mark Manyin at the Congressional Research Service and the Ministry of Unification, we have an estimate of the total insurance pool of about $300 million, with a cap of $6 million per firm. President Park has also personally announced that funds allocated to promote inter-Korean exchange and cooperation (the Inter-Korean Cooperation Fund) will be spent on compensating companies’ losses, although it is unclear whether this was a reference to the insurance commitment or in addition to it.

We honestly don’t see how this will end. An incoming president in South Korea needs to weigh the risks of accommodation: the concessions might be worth it if we could believe that there were corresponding gains forthcoming. The opposition in South Korea is scrambling to accommodate the North’s posturing and as always, Lee Sigal makes the case for striking a deal.  He hopefully argues that we should explore “whether the new strategic line of March 31 has ruled out negotiated limits on its nuclear and missile programs.” How he can reach the conclusion that the North is interested in a serious negotiation on these issues escapes us entirely. But the offer has to remain on the table, and Sigal rightly focuses on the ongoing significance of China’s posture. On this point, we are in agreement with Sigal: this is a great opportunity for US-China relations after the rocky run of the last three years.

Of note: Dan Pinkston at the International Crisis Group has a short, sharp post on the bargaining dynamics. Our other posts on the KIC can be found here. Next week; an analysis of trade into and out of the zone.