Rebooting Inter-Korean Economic Relations: A Challenging Road Ahead
The dramatic shift in inter-Korean relations now underway provides a strategic opportunity to rethink future economic cooperation between the two Koreas. The nearly blank slate created by the May 24 measures in 2010 following the sinking of the ROK warship Cheonan and the closure of the Kaesong Industrial Complex in 2016 offers a unique opportunity to set new objectives and priorities for both Koreas in shaping their economic future in ways that will serve their longer-term as well as immediate interests. Notably in the April summit, neither President Moon nor Chairman Kim included senior economic officials in their delegations, reflecting a wise understanding that appearing to jump the gun on the delicate questions of commitment to denuclearization and stage-setting for a summit between President Trump and Chairman Kim could undermine the potential for moving forward on the economic front.
Nevertheless, the April 2018 summit declaration included agreement “to actively implement the projects previously agreed in the 2007 October 4 Declaration in order to promote balanced growth and co-prosperity of the nation. As a first step, the two sides agreed to adopt practical steps towards the connection and modernization of railways and roads on the eastern transportation corridor as well as between Seoul and Sinuiju for their utilization.” The 2007 Summit Declaration included an agreement to promote investments in natural resources and infrastructure and preferential conditions and benefits for inter-Korean projects. It highlighted the expansion of the Kaesong Industrial Complex; rail, road and cooperative shipbuilding projects; and projects in agriculture, health and medical services, and environmental protection. Beyond these formal statements of intent, an informal private conversation about future inter-Korean economic relations did reportedly occur during the April Moon-Kim Summit, with President Moon conveying a USB stick to Chairman Kim with details of South Korean ideas.
Before rushing to reboot inter-Korean economic relations, it is imperative that South Korean policymakers assess the lessons of the Sunshine Policy as well as the dramatic changes in the context for bilateral economic cooperation that have evolved since 2010 when existing modalities for cooperation began a downward spiral. These include not only the advances in North Korea’s military threats and the efforts to ratchet up the sanctions regimes, but also the significant changes taking place inside North Korea, such as the expanding role of markets, the rise of an economic middle class of successful entrepreneurs and the priority Kim Jong Un has given to economic development. Also, the path of diplomacy currently underway will most likely significantly alter the international context for future inter-Korean economic relations, both as a component of a negotiated denuclearization process and as other countries shape their future economic relations policies towards the North.
Lessons from the Era of the Sunshine Policy
The hallmark success of the Sunshine Policy was the multi-dimensional character of inter-Korean relations. By simultaneously pursuing advances in economic cooperation in trade and investment, humanitarian assistance provided by both government and civic groups, family reunions, cultural and sports activities, and confidence building measures between the two militaries, North-South relations evolved beyond the previous one-issue-at-a time approach. Concrete advances in all of these areas lowered tensions and demonstrated that inter-Korean relations can produce cooperation and mutually beneficial activities.
The negative aspects of the Sunshine era were two-fold. One was the over-reliance on a strategy of providing cash for concessions. Whether overt or under-the-table, these gifts reinforced the impression that South Korea was willing to buy or bribe its way to achieve its national objectives. This only served to undermine efforts to help the North Korean leadership adopt more businesslike ways of conducting relations with South Korea and other countries; it also certainly influenced their behavior in seeking rewards for concessions in the Six-Party Talks aimed at reducing North Korea’s nuclear threats, and engendered American frustrations expressed in an unwillingness to “buy the same horse twice.”
The second negative aspect of the Sunshine era policies was acceptance of aid and trade arrangements that effectively propped up the status quo in Pyongyang, rather than provide incentives for systemic changes that would be more conducive to the growth of a market economy. Specific examples are: (a) wage payments in US dollars for North Korean workers in the Kaesong Industrial Complex (KIC); these payments and foreign exchange went to state coffers with no transparent linkage to what the workers actually earned; (b) the use of commissions, which allowed North Korean trading companies to act as intermediaries and permitted payments for services rendered by North Korean production firms to be transferred directly to state coffers; and (c) transfers of fertilizer, rice and other humanitarian assistance on a government-to-government basis that propped up the Public Distribution System rather than expand the role of markets, and allowed rents for those goods to accrue to senior government officials, not to needy North Koreans.
Two counterexamples to this pattern of distorting incentives of South Korean economic cooperation were: (a) the decision by Hyundai Assan—when the Mount Kumgang Tourism project appeared to be headed for bankruptcy—to switch from an agreement to pay North Korea a fixed amount per month to an arrangement to share tourist receipts, thereby giving North Korea a stake in the economic success of the project; and (b) the use of Choco Pies to give North Korean workers in the KIC an incentive for performance by allowing them to sell their products in North Korean markets for considerable cash value that is not siphoned off by the government.
The primary lessons to be learned from the Sunshine era for future inter-Korean relations are thus to: (a) revert to a robust multi-dimensional relationship where issues needing to be resolved in one area do not necessarily lead to breakdown of cooperative engagement on other areas in the relationship; and (b) establish economic relations based on good business practices that will help the North Korean economy develop in appropriate ways for eventually participating in the international economic system, and longer-term integration with the South Korean economy based on market principles. This means more emphasis on trade and investment at the enterprise-level rather than government-to-government aid, and practices which support the development of North Korean enterprises to be successful in rules-based and transparent market-based activities, both domestically and in inter-Korean and international economic cooperation.
North Korean Realities Today
Under Kim Jong Un, the North Korean economic system has been evolving rapidly and economic development has been given equally high priority with the nuclear and missile programs under the byungjin policy, formally adopted at the 7th Party Congress in 2016. Kim Jong Un has tethered the legitimacy of his leadership to delivering on his promises to improve the livelihoods of all North Koreans, not just the elite. This provides new openings for building future inter-Korean economic relations that should be explored in order to secure commitments to priorities and specific modalities of cooperation that resonate with North Korean, as well as South Korean goals, and thus provide a firmer foundation for sustained cooperation with mutual benefits.
Kim Jong Un’s tolerance for the expanding marketization of the economy and growing role of successful private entrepreneurs, together with the adoption of a new five-year economic development strategy under the guidance of the Cabinet, provide a very different context for shaping future economic engagement with South Korea than existed under the Sunshine era. Estimates of the size of the North Korean market economy are that there are about 450 officially licensed markets and 750 unlicensed markets, and market activity now accounts for about 30% of the North Korean GDP. A large majority of the population derives most of their income from market activity. Many state enterprises participate in the market economy by providing legal cover to private enterprises for a price, sourcing inputs to their own production from the market, and/or selling part of their production over the state quota to the market directly.
The regime has also allowed local officials and state enterprises to enter into economic deals with private entrepreneurs. Such practices include contracting a state-owned business to be managed privately, use of state factory buildings for private production activities, and lease of locally owned agriculture land for housing development. Thus, the boundaries between the state-managed economic system and market economy are becoming increasingly blurred. China’s economic engagement with North Korea is a major factor that has reinforced these developments and is one reason China may be reluctant to enforce economic sanctions tightly. These dynamics of economic systemic change raise important questions for future South Korean economic engagement strategy—in particular, whether and how it can be designed to reinforce the marketization of the North Korean economic system, encourage policy reforms and institution-building to support a growing mixed economy, and provide direct benefits to the North Korean people.
Laws that have been adopted for North Korean Special Enterprise Zones (SEZs) are also very different from the agreements governing the operations of the KIC and are based on efforts to learn lessons from the experience of other countries use of SEZs to promote their economic development. Among other features, these include rights to set salaries and pay workers directly, opportunities to form joint ventures, access to financial and other services for investors, and legal protections against various risks. This also raises an important question for a future South Korean strategy of reopening the KIC and Mount Kumgang. If North Korea has accepted commercial and not politically driven rules used in other SEZ’s (including potential South Korean participation in these other zones), should South Korea press for adopting similar rules in restructured agreements for KIC and Mount Kumgang? Specifically, issues worth exploring are allowing or promoting direct payment to employees; direct joint ventures between South and North Korean enterprises; sourcing of inputs for production from North Korean suppliers in addition to South Korean suppliers; backward linkages to small and medium-sized North Korean enterprises and markets; and use of banking institutions for settlements.
In addition to the internal developments in the North Korean economy, the impact of bilateral and UN Security Council sanctions needs to be carefully assessed in shaping a reset of inter-Korean economic cooperation. Even an effort to simply reopen KIC in the same form when it was closed in 2016 would be compromised by the tightening of sanctions last year, and the determination of the Trump administration to seek more severe and effective implementation of sanctions to add pressures on North Korea. The future parameters for reopening KIC could also be addressed in the renegotiation of the bilateral KORUS trade agreement that is currently under discussion for South Korea’s future trade relations with the United States.
One impact of sanctions has been to give North Korea greater incentives to seek cash transactions and non-transparent trade-using front companies willing to act as intermediaries with third parties. Given past experience, cash for concessions in inter-Korean relations should not be resumed in this environment. South Korean enterprises will need to be transparent with the South Korean government as to their business dealings with North Korean enterprises in order to avoid the challenges now facing the Chinese government in reigning in front companies profiting from North Korea’s need to earn foreign exchange in non-transparent ways.
On the other hand, sanctions are also creating incentives for both state and non-state North Korean actors to seek non-sanctioned economic activities to earn foreign exchange and to increase efficiency in domestic production and value-added in exports. This may provide new opportunities for collaboration in KIC, rebuilding processing-on-commission trade, and the design of other inter-Korean economic ventures. A challenge for future economic engagement policy is how to select activities that do not run afoul of the sanctions regime or reinforce North Korean efforts to evade sanctions, while at the same time promoting non-sanctioned economic activities that support improvement in efficiency and equity in the changing North Korean economic system.
Inter-Korean Economic Cooperation and Denuclearization
The short-term challenge for President Moon and his advisors is how to establish an inter-Korean economic engagement strategy that meshes effectively with the objective of successfully negotiating and implementing a broadly supported denuclearization and missile program agreement North Korea. There are procedural and substantive aspects to this challenge, and both require open-minded consultations with all concerned parties to seek agreement on a path forward. Now is the time to incorporate a thoughtful economic dimension into the negotiations and consultation with concerned parties on a coordinated policy for providing economic incentives and modalities for meaningful progress on the political process that leads to a new security environment on the Korean peninsula.
Ultimately, if a peace accord and new security arrangements are achieved and North Korea pursues the path of becoming a normal state integrated into the international economy, inter-Korean economic relations will need to balance peninsular unification objectives with North Korea’s future economic relations with China, Japan, Russia, and the US, all of which can be expected to pursue their own national interests. In addition to advancing its own national interests, South Korea should advocate for North Korean membership in the IMF as an early step in the normalization process, both to demonstrate commitment of transparency in reporting national accounts and balance of payments that will be essential for future investment and Official Development Assistance from the international community, but also as a necessary step towards receiving investments from international development banks to spread the burden of financing that will be needed. Ideally, the international community would eventually support an economic development strategy for North Korea that enables lifting of sanctions and integration in the international economy in which future evolution of inter-Korean economic relations should have a clearly defined role and benefit both Koreas.
“Full Text of joint declaration issued at inter-Korean summit,” Yonhap News, April 27, 2018, http://english.yonhapnews.co.kr/news/2018/04/27/0200000000AEN20180427013900315.html.
The National Committee for North Korea, “Declaration on the Advancement of South-North Korean Relations, Peace and Prosperity,” https://www.ncnk.org/resources/publications/North-South%20Declaration.doc.
Tara Francis Chan, “Kim Jong Un received a USB from South Korea’s president with a blueprint for connecting North Korea with the world,” South China Morning Post, May 7, 2018, http://www.scmp.com/news/asia/east-asia/article/2144939/kim-jong-un-received-usb-south-koreas-president-blueprint?__s=3fahukt5syn1ug8oxbjp&utm_source=drip&utm_medium=email&utm_campaign=2018-05-07+DAILY+UPDATE.
Elizabeth Shim, “North Korean regime legitimizing country’s expanding markets, study says,” UPI, November 21, 2016, http://www.upi.com/Top_News/World-News/2016/11/21/North-Korea-regime-legitimizing-countrys-expanding-markets-study-says/2451479739417/; Boo Jang-won, “Market economy represents nearly a third of N.K. domestic consumption,” Pulse News, October 31, 2016, http://pulsenews.co.kr/view.php?sc=30800022&year=2016&no=759057.
For a more detailed discussion of the new SEZ laws, see Bradley Babson, “North Korea’s Push for Special Economic Zones: Fantasy or Opportunity,” 38 North, December 12, 2013, http://38north.org/2013/12/bbabson121213/.