Will a New South Korean Policy for Inter-Korean Relations Help or Hinder Economic Reform in North Korea?

It is now clear that following the South Korean Presidential elections this week there will be a realignment of the ROK’s North Korea policy. Both the conservative candidate Park Geun-hye and liberal candidate Moon Jae-in have set forth their visions of how they would aim to reshape inter-Korean relations, and both see renewed economic engagement as an important part of their future policy. Regardless who wins, hitting the reset button as a new administration takes shape in 2013 will pose a major challenge for both Koreas as they assess the legacy of five years of stagnation in cooperation as well as increased tensions that have heightened the risk of conflict. Any realignment of inter-Korean relations will need to take into account historical challenges and legacies and current conditions in the two Koreas. In that context, economic as well as political factors will be important determinants of the space for recalibrating cooperation. The successful launch of a long-range missile on December 12 only adds to the urgency of seeking creative new ways to engage North Korea.

Two such economic factors are likely to be particularly salient. In the North, Kim Jong Un’s public pronouncement in his inaugural speech on April 15 that the Party is determined to ensure that the people will not have to tighten their belts again, ups the ante for delivery on economic performance and even regime legitimacy. North Korean motivation to find a way to meet this commitment may provide new space for economic engagement. In the South, the labor force will begin to shrink in 2013, raising the prospect of needing to seek new sources of labor to support economic growth in the coming years. The attractiveness of low cost North Korean labor for South Korean enterprises is likely to increase willingness to pursue new commercial arrangements in the North.

The two Koreas enter this period of realignment with a nearly blank slate on economic cooperation. Following the sinking of the ROK Navy corvette Cheonan in March 2010, South Korea adopted the May 24 measures. These measures effectively closed the door on all economic cooperation except for the Kaesong Industrial Complex (KIC), where operation were permitted to continue but with a significantly scaled back number of South Koreans allowed in the complex and limitations on further investments. The sanctions forced the closing down of processing-on-commission trade, inter-Korean economic projects, remittances to North Korea, and other private investment and trade activities. Contacts with North Koreans and travel to North Korea were also forbidden without prior permission from the Ministry of Unification. While humanitarian aid was allowed through private organizations, in practice it dropped precipitously following the adoption of the May 24 measures. Large-scale government transfers of fertilizer and rice that had been provided for many years were also suspended.

The effect of these sanctions has been a significant reduction in foreign exchange transfers and food aid from South Korea to North Korea. This has forced Pyongyang to seek new sources of hard currency to meet its annual deficit in food production, notably through new initiatives aimed at improving domestic agricultural production and distribution and facilitating increased aid and trade with China and other countries. Foreign exchange wage payments to North Korean workers in the KIC are now the main remaining source of foreign exchange that the North receives from the South, though it is widely believed the majority of these wages winds up in the pockets of the ruling elite, not the workers themselves. It is also apparent that economic sanctions have not forced the North to curtail its efforts to expand it nuclear and missile programs, nor to offer any concessions to the South on other issues of concern, such as an apology for the shooting at the Mount Kumgang Tourist resort that led to the shut down of that cooperation project.

The survival of the KIC, even in limited form during this period of chilled relations, is a signal that cooperation that results in genuine mutual economic benefits, with commercial as well as government stakeholders, has value to both Koreas. This carries an important lesson for the future: economic interdependencies that produce real value for both countries can be a means to promote stability as well as economic gain. Seeking opportunities for diversifying such interdependencies should be one principle to follow in rebuilding inter-Korean economic cooperation relationships going forward.

There is no reason to mourn the loss of other economic engagements between the two Koreas. It can be argued that the inter-Korean economic cooperation in past configurations largely served to prop up the status quo in the North and did very little to support the emergence and growth of markets, which have now become an embedded reality in the North Korean economy.

The Sunshine Policy era from 1998-2008 was premised on a political view that multifaceted engagement with the North and an open pocketbook from the South would entice North Korea into a more collaborative relationship. While this policy did result in more diversified interactions and cooperation in areas of mutual interest, the absence of a principle of reciprocity and the willingness to prop up the regime in Pyongyang despite its ongoing provocations in missile and nuclear programs, led to conservative criticism and a shift towards disengagement under the Lee Myung-bak administration. In neither era of South Korean policy towards the North was serious consideration given to using economic engagement to foster needed changes in the North Korea economic system.

Two aspects of South Korean economic engagement during the Sunshine Policy era were, in fact, decidedly unhelpful in influencing the course of economic change in the North. One was the reliance on cash-for-concessions and filling the till of the central authorities at the expense of promoting above-board business practices that are transparent and commercially viable. Both public and private dealings unfortunately ended up being cash cows for the elite in Pyongyang, reinforcing their capacity to use patronage as means of maintaining loyalty and undermining incentives for producers to respond to market signals. Even the wage system at Kaesong falls under this category of diverted foreign exchange and weakened incentives for workers to increase their productivity. (Although clever South Korean firms turned to giving Choco Pies to workers as a means to provide tangible rewards to them, circumventing this system.[1])

The second aspect of South Korean economic engagement that inhibited economic system reform in the North was the large-scale transfer of fertilizer and rice on a government-to-government basis. These transfers essentially served to buttress the failing Public Distribution System in the North, thus delaying its demise and acceptance of markets as the primary mechanisms for food distribution and for obtaining needed inputs for agricultural production. While the humanitarian motivation for these transfers is understandable, the reality is that the Chinese economic engagement policy, which relies much more on cross-border trade through enterprises and small traders, has had much greater impact on the growing role and diversification of markets as the mechanism to meet the consumption needs of the North Korean population. There is no doubt that many North Koreans continue to face real hardship and food deprivation. But the best solution is for Pyongyang to adopt policies to strengthen the role of markets and trade its way to food security, not to rely on aid and a dysfunctional Public Distribution System. Another problem with the top down distribution of large-scale humanitarian food aid is that it is extremely vulnerable to corruption, diverting aid to the markets for cash rather than distributing it to the intended recipients.

The lesson for future humanitarian assistance policy is not to revert to these large-scale commodity transfers which have had negative impacts on the transition of the North’s economy, but to focus on targeted distributions to specific vulnerable groups with verifiable monitoring, as has been agreed to with UN and US humanitarian programs, limited as they are at the present time. Expanded reliance on civic groups for conveying and supervising humanitarian aid would be worthwhile and also have the benefit of diversifying people-to-people contacts.

As the two Koreas gear up for a new round of dialogue on the future shape of inter-Korean relations under the next South Korean president, coming to grips with the political implications of renegotiating economic engagement policies will take center stage. Finding a way to avoid the failures of the Sunshine Policy era’s economic engagement strategies, while balancing the principles of reciprocity and conditionality of the Lee Myung-bak era will be a considerable challenge. While North Korea may not wish to blindly follow South Korea’s lead, re-orienting inter-Korean economic cooperation in ways that will strengthen the market economy in the North and support more decentralized decision-making and allocation of benefits, it is also not likely that the South will be willing or politically able to simply revert to the policies of the Sunshine era, even if the liberal candidate Moon Jae-in wins. Thus some degree of adaptation to shifting political realities can be expected of both sides as they enter a new phase of negotiating future relations.

North Korea now seems to understand that to attract foreign private investment, it needs to improve the incentives environment and address security concerns of investors. The laws adopted in late 2011 for the new Special Enterprise Zones in Rason on the eastern border with China and the Hwanggumpyong and Wihwa Islands on the western border, provide for much more flexibility than the rules in place for the KIC. This applies to business models, land use rights, managerial discretion especially in labor hiring and wage setting, access to financial services in various currencies, legal protections, and dispute resolution mechanisms. While Chinese investors may still be wary, North Korea has come a long way in trying to improve the investment climate, at least on paper. These new laws even contain an explicit invitation to South Korean companies to invest in these Special Enterprise Zones on the same terms as Chinese or other investors.

The question for South Korea as it contemplates expansion of investment in KIC and perhaps other enterprise zones near the Korean border, is whether the rules adopted for the zones on the China border can be adapted to the Korean border. It certainly would be an improvement to allow multiple investment models in an expanded KIC, for example joint ventures between North and South Korean enterprises, and more flexible options on hiring and firing, wage setting, and payments. As a general principle, it would be good for North Korea’s future economic development to place more emphasis on building enterprise-to-enterprise commercial relationships under a clarified legal regime, rather than relying on government involvement in cross-border business dealings. North Korea, for political reasons, may not respond to the opportunity to more closely align its foreign investment policies along the Chinese and South Korean borders, expecting instead that the South Korean government would have greater political will to offer protections to investors and financial inducements to the regime than would the Chinese government. In this case, Seoul will face the choice of insisting on an economically rational policy for the current situation or opting for what will be seen as continued political wrangling between the two governments without an obvious economic rationale.

This principle applies also to the challenge of restarting processing-on-commission trade between the two Koreas, which was halted as a result of the May 24 measures. Under the old system, North Korean trading companies acted as intermediaries between the South Korean and North Korean enterprises involved. Without a direct relationship, there was a lack of transparency in how payments were routed through the trading companies and if compensation was actually received by the production enterprises. This system shielded North Korean enterprises from the international marketplace and did not provide incentives for productivity improvements or motivation to increase profitability of the trade. Cutting out the middle-men should be explored if resuming processing-on-commission trade is on the list for rebuilding inter-Korean economic cooperation.

Another way to leverage the impact of inter-Korean economic relations on the development of the market economy in the North is to promote backward linkages to small and medium-size enterprises outside the Special Economic Zones that can provide inputs for production and services to companies operating inside the KIC and other Special Enterprise Zones. International experience shows that that these backward linkages can be an important mechanism for economic development and job creation in the general economy beyond the borders of the Special Economic Zones themselves.

Finally, the linkage between economic cooperation and the security agenda deserves to be re-thought. The formula adopted by the Six Party Talks was to provide economic rewards for step-by-step progress on the dismantling North Korea’s nuclear capabilities and curtailing the missile program development. While reasonable in principle as a negotiating tactic, the rewards under discussion were not linked to any agreed overall strategy for improving the North Korean economic system and its ability to achieve meaningful economic development. The fact that North Korea and other countries continue to focus on Light Water Reactors rather than a rational energy system development plan reveals the disconnect between the politics of managing the security agenda and the realities of addressing problems in the North Korean economy. Additionally, without an overall economic strategy, the economic engagement policies of the countries involved in the Six Party Talks were fundamentally contradictory, making it impossible to pursue a coherent economic agenda that would be mutually reinforcing. This diversity of policies reflected the different national interests that were being pursued bilaterally, even while participating in a multilateral process of trying to manage change in North Korea’s security policies and behaviors. The diverse national interests at stake may continue to trump reaching a more coherent multilateral approach to economic engagement. However, in the absence of any willingness to contemplate a forced solution to the security issues on the peninsula, the prospects for North Korea to continue to muddle along with an unpredictable and disjointed economic system change process going forward are high.

The policy of reciprocity and economic disengagement pursued by the Lee Myung-bak administration with the parallel policy of Strategic Patience adopted by the Obama administration failed to curtail North Korean nuclear and missile programs, and also accelerated China’s increasingly diversified economic engagement with North Korea. This raises the prospect that one possible future trajectory of the North Korean economy is gradual integration with that of Northeast China, not unification with South Korea.

These realities have implications for a future South Korean engagement policy. Seoul’s bilateral policies should be designed to have some coherence with multilateral engagement policies if they come back into play. Or they should at least be mutually reinforcing with North Korea’s other major economic partners and interested stakeholders, notably China, Russia, Japan, the US, and Europe. Seeking common ground for this coherence should be given priority by the next South Korean administration. Focusing on a common vision of the need for transition to market economy and building the institutions necessary to manage a market economy increasingly linked to an outward-oriented economic development strategy should be the foundation for this effort.

One avenue that should be explored is increasing North Korea’s stake in a multi-dimensional set of cross border commitments that provide real mutual economically sound and commercially viable benefits conditioned by interdependency. This is why the gas pipeline project linking Russia and the two Koreas is a better bet for an economic deal tied to security negotiations than a light water reactor project. Economic security should not be dismissed as an important driver in North Korea’s overall calculus and must be taken into account in any process of trying to walk them down the denuclearization road.

The year 2013 offers a historic opportunity for the two Koreas to realign relations and set them on a pragmatic path that produces mutual benefits and improves prospects for stability, peace, and eventual unification. Economic engagement policies will be at the center not the periphery of any new inter-Korean relationship that aims to advance these important goals. Resolving the nuclear, missile, and other security issues with North Korea should be addressed in the context of these wider challenges facing the Korean peninsula.