North Korean Economy Watch

The Economist
3/11/2004

So far as a visitor can tell in this secretive land, North Korea’s economic reforms are starting to bite. But real progress will require better relations with the outside

COMMUNIST North Korea has started to experiment with economic reform, and opened its door a crack to the outside world. Though its culture of secrecy and suspicion stubbornly persists, it was deemed acceptable for your correspondent to visit Pyongyang’s Tongil market last week. Here, stalls are bursting with plump vegetables and groaning with stacks of fresh meat. You can even buy imported pineapples and bananas from enthusiastic private traders.

But how about a photograph? Most foreigners think of North Korea as a famished nation, and the authorities are evidently keen these days to tell the world about the great strides their economy has made since reforms were introduced in July 2002. Logic might seem to suggest that a snap showing the palpable result of the reforms would be acceptable too. But it is not. The officials were friendly but firm: no pictures of fat carrots.

The July 2002 reforms were ground-breaking for North Korea: the first real step away from central planning since the dawn of communism there in 1945. The government announced that subsidies to state-owned enterprises were to be withdrawn, workers would be paid according to how much they produced, farmers’ markets, hitherto tolerated, would become legal and state enterprises would be allowed to sell manufactured products in markets. Most of these enterprises, unless they produced “strategic items”, were to get real autonomy from state control.

Almost two years on, how to assess the success or failure of these reforms? That climate of secrecy makes it deeply frustrating. Even the simplest of statistics is unavailable. Li Gi Song, a senior economist at Pyongyang’s Academy of Sciences, says he does not know the rate of inflation. Or maybe he is not telling. After all, he says, “We can’t publish all the figures because we don’t want to appear bare before the United States. If we are bare then they will attack us, like Afghanistan or Iraq.” So what follows can be little more than a series of impressions.

The indications are that the reforms are having a big impact. For a start, North Korea has recently acquired its first advertisement (pictured above)—for foreign cars, assembled locally by a South Korean majority-owned company. Or, to be more basic, take the price of rice, North Korea’s staple. Before the reforms, the state bought rice from state farms and co-operatives at 82 chon per kilo (100 chon make one won, worth less than a cent at the official exchange rate). It then resold it to the public through the country’s rationing system at eight chon. Now, explains Mr Li, the state buys at 42 won and resells at 46 won.

North Korea’s rationing system is called the Public Distribution System (PDS). Every month people are entitled to buy a certain amount of rice or other available staples at the protected price. Thus most North Koreans get 300g (9oz) of rice a day, at 46 won a kilo. According to the UN’s World Food Programme (WFP), that is not nearly enough. Anything extra has to be bought in the market.

In theory, even in the market the price of staples is limited. Last week, the maximum permitted rice price was marked on a board at the entrance to Tongil as 240 won per kilo. In fact, it was selling for 250. WFP officials say that in January it was selling for 145 won, which points to significant inflation, for rice at least. This is not necessarily a bad thing, since it means that the price is coming into line with the market.

The won’s international value is also adjusting. Since December 2002, the euro has been North Korea’s official currency for all foreign transactions. In North Korean banks, one euro buys 171 won. In fact, this rate is purely nominal. A semi-official rate now exists and the price of imports in shops is calculated using this.

Last October, according to foreign diplomats, a euro bought 1,030 won at the semi-official rate. Last week it was 1,400. A black market also exists, in which the euro is reported to be fetching 1,600 won—which implies that the won is approaching its market level. It also means, however, that imported goods have seen a big price-hike. For domestically-produced goods, like rice, prices may well go on rising for a good while longer.

What about earnings? Before the 2002 reforms, most salaries lay in the range of 150-200 won per month. Rent and utilities, though, were virtually free, as were (and are) education and health care. Food, via the PDS, was virtually given away. Now, pay is supposed to be linked to output, though becoming more productive is not easy for desk-bound civil servants or workers in factories that have no power, raw materials or markets.

Rents and utilities have gone up, though not by crippling amounts. A two-bedroom flat in Pyongyang including electricity, water and heat costs just 150 won a month—that is, about a tenth of a euro.

Earnings have gone up much more: a waitress in a Pyongyang restaurant earns about 2,200 won a month. A mid-ranking government official earns 2,700. A worker at a state farm earns in the region of 1,700, a kindergarten teacher the same, and a pensioner gets between 700 and 1,500. A seamstress in a successful factory with export contracts can earn as much as 5,000 won a month. Since that seamstress’s pay equates to barely three euros a month, wages still have a long way to adjust.

The prices of food and other necessities, to say nothing of luxuries, has gone up much more than rent has. According to the WFP, some 70% of the households it has interviewed are dependent on their 300 gram PDS ration, and the WFP itself is targeting 6.5m vulnerable people out of a total population of some 23m. Not all suffer equally: civil servants in Pyongyang get double food rations from the PDS.

There are some encouraging stories. In Pukchang, a small industrial town 70km (40 miles) north-east of Pyongyang, Concern, an Irish aid group, has been replacing ancient, leaking and broken-down water pipes and pumps, and modernising the purification system. This has pushed the amount of clean water available per person per day from 80 to 300 litres. Kim Chae Sun is a manager at the filtration plant, which is now more efficient. Before July 2002 she earned 80 won a month. Afterwards she earned 3,000 won. Now she earns 3,500.

As Mrs Kim speaks, three giant chimneys belch smoke from the power station that dominates the town. All workers have been told they can earn more if they work harder, but certain groups have been told they will get even more money than everyone else. In energy-starved North Korea these include miners and power workers. Mrs Kim says her husband, who works in the power plant, earns an average of 12,000 won a month. Her rent has gone up from eight to 102 won a month, and in a year, she thinks, she will be able to buy a television or a fridge.

A lot of people, in fact, are buying televisions. The women who sell the sets from crowded Tongil market-stalls get them from trading companies which they pay after making a sale. The company price for an average set is 72,000 won, the profit just 1,000 won. After they have paid for their pitch, the traders can expect an income of 10,000-12,000 won a month.

Mystery sales
Which makes for a puzzle. Who can afford a good month’s salary for a locally made jacket in Tongil, costing 4,500 won? How come so many people are buying televisions, which cost more than two years of a civil-servant’s pay? How come the number of cars on the streets of the capital has shot up in the past year? Pyongyang still has vastly less traffic than any other capital city on earth, but there are far more cars around than a year ago. Restaurants, of which there are many, serve good food—but a meal costs the equivalent of at least a white-collar worker’s monthly salary. Many of these restaurants are packed.

Foreign money is part of it. Diplomats and aid workers say many new enterprises seem to have opened over the last year. Nominally they are state-owned, but sometimes they have a foreign partner, often an ethnic Korean from Japan. The majority are in the import-export business. Some have invested in restaurants and hotels and some in light industry. Thanks to the 2002 reforms, these firms have a degree of autonomy they could not have dreamed of before. An unknown number of people also receive money from family abroad, but there are still no North Korean-owned private companies.

Farmers are among the other winners: they can sell any surpluses on the open market. But two out of three North Koreans live in towns and cities, and only 18% of the country is suitable for agriculture. The losers include civil servants, especially those outside Pyongyang who do not get double food rations and have no way to increase their productivity.

Factory workers have it the hardest. A large proportion of industry is obsolete. Though Pyongyang has electricity most of the day, much of the rest of the country does not. Despite wild talk of a high-tech revolution, the country is not connected to the internet, though some high-ups do have access to e-mail service. In the east of the country lies a vast rustbelt of collapsing manufacturing plants.

Huge but unknown numbers of workers have been moved into farming, even though every scrap of available land is already being cultivated. The extra workers are needed because there is virtually no power for threshing and harvesting and no diesel for farm vehicles. This requires more work to be done by hand. Ox-carts are a common sight.

The innocent suffer
Markets are everywhere. But this does not mean that there is enough food everywhere. In Pyongyang, where there are better-off people to pay for it, there is an ever-increasing supply. Outside the capital, shortages are widespread.

No one knows how many died during the famine years of 1995-99; estimates range from 200,000 to 3m. In Pukchang, officials say that 5% of children are still weak and malnourished. In Hoichang, east of Pyongyang, schools and institutions tell the WFP that about 10% of children are malnourished. Masood Hyder, the senior UN official in North Korea, says that vulnerable households now spend up to 80% of their income on food.

And yet some things are improving. Two surveys carried out in 1998 and 2002 by the North Korean government together with the WFP and Unicef showed a dramatic improvement in children’s health between those years. The proportion of children who fail to reach their proper height because of malnutrition fell from 62% to 39%, and the figures are thought to be still better now. However, Unicef says that though children may no longer die of hunger, they are still dying from diarrhoea and respiratory diseases—which are often a side-effect of malnutrition.

To a westerner’s eye, a class of 11-year-olds in Hoichang is a shocking sight. At first, your correspondent thought they were seven; the worst-affected look to be only five. Ri Gwan Sun, their teacher, says that apart from being stunted some of them still suffer from the long-term effects of malnutrition. They struggle to keep up in sports and are prone to flu and pneumonia. They are also slower learners.

Pierrette Vu Thi of Unicef says that North Korea’s poor international image makes it hard for her agency, the WFP and others to raise all the money they need. The country is in a chronic state of emergency, she says, and to get it back on its feet it would need a reconstruction effort on the scale of Afghanistan and Iraq.

Such bleak talk is echoed by Eigil Sorensen of the World Health Organisation. He says that health services are extremely limited outside the capital. Medicines and equipment are in short supply, large numbers of hospitals no longer have running water or heating and the country has no capacity to handle a major health crisis.

None of this is likely to change very fast. With no end yet to the nuclear stand-off between North Korea and the United States, American and Japanese sanctions will remain in place. And nukes are only part of it. Last week the American State Department said it was likely that North Korea produced and sold heroin and other narcotics abroad as a matter of state policy. North Koreans who have fled claim that up to 200,000 compatriots are in labour camps. North Korea denies it all.

Reform, such as it is, has plainly made life easier for many. But rescuing the North would take large amounts of foreign money, as well as measures more far-reaching than have yet been attempted. At present, there is no way for the government to get what it needs from international financial institutions like the World Bank. Such aid as comes will be strictly humanitarian, and investment in so opaque a country will never be more than tentative. Domestic reform on its own cannot fix an economy wrecked by decades of mismanagement and the collapse of communism almost everywhere else.

Washington Post Foreign Service
Anthony Faiola
September 14, 2003

Notes on the DPRK’s new Fiat:

The first commercial billboards (ever) are going up in Pyongyang.  Fiat is in the Hermit Kingdom.  The billboards are part of what is dubbed the first corporate media blitz to hit North Korea.

Pyeonghwa Motor Corps., a South Korean firm with ties to the Unification Church, coaxed the DPRK government into allowing the campaign.  Pyeonghwa began assembling cars in North Korea 18 months ago using imported Fiat parts.

Creating the ad campaign was not easy, said John Kim.  The government rejected many billboard proposals.

The company began publishing asd in government sponsored trade magazines showcasing the “Whistle” (The name of the car in the DPRK.  Named after a famous song).  Also a SUV model was launched.  Commercials have also appeared on TV.

Cars cost $14,000 and it would take a north Korean 15 years of labor to save up enough money.

When Pyeonghwa opened its $20m factory about 40 miles west of Pyongyang last year, the company hoped to sell 1000 cars in 12 months, but it has unloaded only half that number in 18 months.  Most have gone to government officials and diplomats.

There are only two gas stations in Pyongyang, and the company does not offer financing 

Notes on Politics:

Pyongyang’s news agency recently described new markets as desigend to “dramatically improve the country’s standard of living.”

This month, the North Korean’s announced a cabinet reshuffle that raised Pak Pong Ju, a former chemical industries manager, to the loftier position of Premier.  He is seen as being interested in reforms.

Kim Jong Il has been working to give the authority to fire a worker to factory managers, as opposed to Party officials.

Washington Post
John Pomfret
1/27/2003, Page AOl

Nuclear Crisis May Have Roots in Economic Failure

Six months after North Korea announced unprecedented wage and price increases to jump-start its miserable economy, runaway inflation is emptying millions of pocketbooks and bottlenecks in production are causing widespread shortages, according to Chinese and North and South Korean sources.

The black market price of rice, the staple of the Korean diet, has jumped more than 50 percent over the past three months in most parts of the country while tripling in others, according to North Koreans, Chinese businessmen and Western aid agency workers. Some factories in poorer parts of the country, such as the heavily industrialized east coast, have stopped paying workers the higher salaries that were a cornerstone of the reforms, recent North Korean arrivals to China said. Others have taken to paying workers with coupons that can be exchanged for goods, they said, but there are no goods in the stores to buy.

“Theft new economic policy has failed,” said Oh Seung Yul, an economist at the government-funded Korea Institute for National Unification in Seoul. “The hopes that were raised in July are today pretty much dashed.”

The apparent failure of North Korea’s attempt to promote economic activity and improve living standards constitutes an important backdrop for its recent threats to resume a nuclear weapons program, according to the sources.

On one hand, Oh and others said, North Korea’s isolated government needed a scapegoat. On the other, according to Chinese sources close to the secretive government of Kim Jong Ii, Pyongyang has determined that it risks economic collapse without security guarantees and access to international lending institutions such as the World Bank and International Monetary Fund, to which the United States holds the keys. So Kim manufactured a crisis to win concessions, they said.

“Now the economic situation is more precarious than before the reforms. They can’t do this halfway,” said Cui Yingjiu, a Chinese Korean economist and adviser to the North Korean government. “They risk social chaos and economic collapse.”

The crisis has been exacerbated by a drop in the humanitarian aid that had kept North Korea on life support since 1995. Because of a shortage of donations, the World Food Program has cut back the number of North Koreans it is assisting this year from 6.4 million to 3.5 million of the country’s estimated 22.6 million inhabitants. In September, the elderly and primary school-age children on the west coast were cut off. In October, kindergarten-age children, pregnant women and nursing mothers there lost out. In November, nurseries were scratched from the list.

“It’s a tough call deciding who has to be deprived,’ said Gerald Bourke, an official with the World Food Program in Beijing. Bourke said the recent “very rapid inflation” of rice prices is “putting food way beyond the pale for a lot of people.”

The World Food Program has 25,000 tons of food in North Korea and pledges of 75,000 additional tons, he said. It needs 511,000 tons this year.

North Koreans traveling over the border to Yanji, about 700 miles northeast of Beijing, said an initial wave of hope triggered by the changes announced in July is gone in almost all parts of the country except the capital, Pyongyang.

Lee Xiangyu, a North Korean refugee in China, was arrested by Chinese border police and returned to North Korea last summer, when the changes began. After a short stint in jail, the 19-year-old returned to her home town, Musan, along the border with China. By October, she said, the lumberyard where her father worked had stopped paying him and other workers the huge raises they had received as part of the effort to promote some aspects of a free-market economy.

But prices continued to rise. “There was no money in my house, and now the prices are so high,” she said. Lee sneaked back into China in December. “It’s not like it was in 1997 when people were starving to death,” she said, speaking of the famine that cost hundreds of thousands of lives. “But it’s worse in a way. Because everybody had hope for a little while and now they are desperate again.”

North Korea’s announcement of economic reforms was front-page news, in part because the measures fit into a series of other moves that led some observers to conclude Kim was ready to lead his country out of isolation. The steps included expression of regret following a clash between North and South Korean naval forces in June, the suggestion that North Korea would hand over Japanese Red Army members wanted in Japan for hijacking a Japanese airliner in 1970, an informal meeting in July between North Korean Foreign Minister Paek Nam Sun and Secretary of State Cohn L. Powell, transportation links between North and South Korea, a summit between Kim and Japanese Prime Minister Junichiro Koizumi and talk of establishing as many as five special zones for foreign investment.

The economic changes included raising prices and wages, devaluing the North Korean won against the dollar and cutting state subsidies for failing businesses. Wages were increased between 900 percent and 1,500 percent. Prices, which are in theory set by the state, went up as well. Rice went up 4,000 percent, corn 3,700, pork 700, diesel fliel 3,700, electricity 5,900, apartment rent 2,400 and subway tickets 900.

The government announced that factories with bloated workforces could effectively lay off unnecessary workers so they could concentrate on making things again — a step North Korean industry had not taken since economic troubles began in 1995.

The main motivation for increasing the price of rice was to prompt farmers to plant more food. But Cui, who attended a conference on North Korea’s economic changes last fall in Pyongyang, said farmers were not happy.

“Grain prices went up, but so did prices for inputs like fertilizers and seeds,” he said. ‘So all gains were canceled out.”

Another issue, Cui said, is electricity. North Korea has good hydropower resources, but as farmers become interested in planting more crops, they will want to use water in reservoirs for irrigation, not for power generation. “There are a whole series of these conundrums and Catch 22s,” Cui said.

He said North Korean factories have yet to begin producing goods people want to buy. That is why trucks rolling into China from the Dandong border crossing, 350 miles southwest of Yanji, now carry clothes, television sets, shampoo and other consumer goods.

The changes befliddled Western and Chinese economists from the beginning. Chinese experts noted that when China undertook its first major economic reform in 1979, it increased the price of grain by only 25 percent. Second, they said, when China began this process, 80 percent of its population lived in rural areas, so there was a huge pooi of potential beneficiaries from the liberalized agricultural policies. But North Korea is highly industrialized: Two-thirds of its people live in cities.

Marcus Noland, at the Institute for International Economics in Washington, speculated that the changes were either a desperate attempt to jump-start a half-dead economy or a backhanded attack against North Korea’s nascent private economy. Increasing prices would reduce the value of currency held outside the state system, breaking the back of private entrepreneurs.

But then again, he said in a recent paper, “the possibility that economic decisions are being made by people who do not grasp the implications of their actions should not be dismissed toohastily.”

Correspondents Doug Struck and Peter £ Goodman in Seoul contributed to this report

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Time
Donald McIntyre
10/19/2002

Lee Mi Young crossed the Tumen River from North Korea into China a month ago. Now she is hiding in a safe house in China, getting help from a Chinese-Korean missionary, and hoping to start a new life. She is terrified to be talking to the first foreigner she has ever seen, more so because she is painting a negative picture of her country. She could be executed in North Korea for this conversation (Lee Mi Young is a pseudonym).

In her mid-30s, with pretty, bright brown eyes and carefully stenciled eyebrows, Lee says she left North Korea because she was tired of never having quite enough to eat. Things are better than they were during the famine of the mid-’90s, but they have begun to deteriorate since July when North Korea announced a series of economic reforms that many observers said signaled the start of a serious effort to fix the country’s collapsed command economy. The government raised the salaries of workers such as miners and teachers, increased the cost of state rations such as rice and allowed the North Korean won to fall to about 150 to the dollar, much closer to its real black-market value than the 2.5 won to the dollar at which it had previously been pegged.

Lee says that in her hometown north of Pyongyang (she prefers we don’t name it) the price of grain in the black market has risen, but people can’t afford to buy it: Although salaries have been raised, the government has only actually paid them once since July. People need to supplement meager government rations with rice bought at exorbitant prices on the black market. “This was a reform for the rich,” says Lee. “Things are worse than before.”

Kim Jung Il is still fully in control of the country, analysts say. There are periodic reports of small signs of dissent — anti-government leaflets and graffiti, for example. Some defectors say family members will complain among themselves and possibly with friends. But North Korean defectors say that everyone is aware that anybody caught protesting publicly will be sent to a harsh prison camp, where they will be joined by members of their family. Lee, the young woman who fled last month, says she saw an old lady standing in line waiting for rations in August who suddenly said: “It is so difficult to live here. I can’t stand this.” Almost immediately, a man came up, tapped her on the shoulder and led her away. Other members of her family later disappeared without explanation.

What has changed in the past few years is the amount of knowledge about the outside world flowing into the country. Hundreds of aid workers have been in and out of the country in recent years, bringing with them new ideas and information. Thousands of North Koreans have crossed across the Tumen River into China attempting to flee or simply looking for food. Many come back not only with food, but also bearing tales of the wonders of China’s booming cities and stores brimming with goods. According to one defector, Chinese-Koreans are bringing cell phones into North Korea, using them along the border and even leaving them behind for relatives to use — in a country where ordinary people don’t have landline phones in their homes.

For impoverished North Koreans, China’s flashy modern cities seem like paradise and many dream of going there. There is much more knowledge about South Korea as well. North Korean propaganda for years portrayed the South as a land of beggars oppressed by a rich elite. Many average North Koreans now know that isn’t true, according to defectors. One reason: North Korean sailors, traders and workers who have been to places like Cuba and Libya come back with video tapes of American action movies. These are secretly circulated, with eager audiences gathering at the house of the very rare family rich enough to have a VCR player, sometimes with an English-speaker on hand to translate the dialogue. A record 600 North Korea defectors arrived in Seoul last year — this year’s figure could top 1,000.

Some analysts argue the clash in the West Sea on June 29 (in which North Korea patrol boats fired on South Korea naval vessels, killing five sailors) was the work of disgruntled military leaders trying to warn Kim Jong Il to keep a lid on change. The conventional wisdom has always been that North Korea is afraid to open the door a crack because the system could unravel so quickly. Some defectors and aid workers report that there is a sense of instability and uncertainty in the country right now. Rather than the start of reform, we may be seeing a country starting to unravel already.

When I visited Pyongyang in August, it looked better than it had even six months earlier. There were open-air restaurants offering grilled meat — just like in Seoul — and people looked healthy and even vibrant. But the capital has always been an oasis reserved for party members and North Koreans loyal to the regime. Aid workers and diplomats say smaller cities lack regular electricity and people still can’t get enough to eat. They probably aren’t starving but malnutrition remains widespread.

North Koreans who live in the countryside may be marginally better-off than their urban cousins, because they are able forage for wild plants in the mountains and are allowed to grow vegetables on small private plots. Life is harsh for city dwellers dependent on the industrial economy. On the road from Pyongyang to the northeast corner of the country, you pass mile after mile of rusting factories — probably less than one third of the country’s factories are actually running.

A Korea-American businessman who visited the city of Kaesong recently was shocked to learn it had had no electricity for 10 days. The only electric lights shining at night in Kaesong those illuminating monuments to the late “Great Leader” Kim Il Sung. Many city have electricity at certain times of the day. Foreign reporters who visited Shinuiju last month, for the unveiling of a plan to turn it into a free economic zone designed to lure investors, were struck by the contrast with the neighboring Chinese city of Dandong. Dandong at night is a blaze of lights; across the river, Shinuiju is in near-total darkness. Apartment blocks in Pyongyang are lit at night these days, but there are few lights outdoors — except, of course, those illuminating the gigantic statue of the “Great Leader.”

To make a go of “special economic zones” such as Shinuiju, North Korea needs to massive foreign investment to rebuild its electrical grid and other key infrastructure. The country has never been self-sufficient in food and needs an industrial economy to make fertilizer to boost agricultural yield and to finance food imports to make up the shortfall. But the disappearance of foreign subsidies following the collapse of the Soviet Union saw a rapid de-industrialization — until the late 1960s, it had been ahead of South Korea economically. North Korea is now dependent on international food aid and donations of fertilizer, and desperately needs to get on the right side of the U.S. in order to get the loans it desperately needs from the World Bank — loans that the U.S. is now blocking. That has many South Korean analysts suggesting that the reason Pyongyang sudden nuclear confession is precisely that it hopes to put its nuclear weapons program on the table and trade it away for economic gains and security guarantees from Washington.

From the Institute for International Economics:

West-Bound Train Leaving the Station: Pyongyang on the Reform Track

Marcus Noland
Institute for International Economics

Paper prepared for the Council on US-Korea Security Studies
Seoul, Korea
October 14-15, 2002

Marketization

The North Korean economic reforms that began in July 2002 have four components: marketization, inflation, special economic zones, and aid-seeking. Marketization, in turn, has several features.1 The government appears to be attempting to adopt a dual-price strategy similar to what the Chinese have implemented in the industrial sphere. In essence the Chinese instructed their state-owned enterprises to continue to fulfill the plan, but once planned production obligations were fulfilled, the enterprises were free to hire factors and produce products for sale on the open market. In other words, the plan was essentially frozen in time, and marginal growth occurred according to market dictates.

The government has announced a scrapping/downsizing/attenuation of the system of distributing goods and services through rationing (including the public distribution system (PDS) for food), meaning that at the household or retail level, the allocation of goods will increasingly occur through markets and on market terms. (Two exceptions are health care and education that will continue to be supplied gratis by the state.)

One can question the extent to which this is a real policy change and how much this is simply a ratification of system—fraying that had already occurred—there is considerable evidence that most food, for example, was already being distributed through markets, not the PDS. In this respect, the North Korean move could be interpreted as an admission that the genie is out of the bottle.

On the production side, enterprises have been instructed that they are responsible for covering their own costs—that is, no more state subsidies. Modest changes in the organization of production have been introduced in agriculture and there are rumors that more dramatic changes in the agricultural sector are on their way. Yet it is unclear to what extent managers outside of agriculture have been given the power to hire, fire, and promote workers, or to what extent remuneration will be determined by the market. Moreover there has been no mention of the military’s privileged position within the economy and domestic propaganda continues to speak of a “military-first” political path.

The state has administratively raised wage levels, with certain favored groups such as military personnel, party officials, scientists, and coal miners receiving supernormal increases. (For example, while it has been reported that military personnel and miners have received wage increases on the order of 1,500 percent, the increases for office workers and less essential employees are less, and the estimated income increase for agricultural workers may be on the order of 900 percent.) This alteration of real wages across occupational groups could be interpreted as an attempt to enhance the role of material incentives in labor allocation.

The state continues to maintain an administered price structure, though by fiat, the state prices are being brought in line with prices observed in the farmers’ markets. This is problematic (as it has proven in other transitional economies): the state has told the enterprises that they must cover costs, yet it continues to administer prices, and in the absence of any formal bankruptcy or other “exit” mechanism, there is no prescribed method for enterprises that cannot cover costs to cease operations, nor, in the absence of a social safety net, how workers from closed enterprises would survive. What is likely to occur is the maintenance of operations by these enterprises supported by implicit subsidies, either through national or local government budgets or through recourse to a reconstructed banking system. Indeed, the North Koreans have sent officials to China to study the Chinese banking system, which although may well have virtues, is also the primary mechanism through which money-losing state-owned firms are kept alive.

Inflation

The likelihood is increased by the second component of the economic policy change, the creation of enormous inflation. At the same time the government announced the marketization initiatives, it also announced tremendous administered increases in wages and prices (Table 1). To get a grasp on the magnitude of these price changes, consider this: when China raised the price of grains at the start of its reforms in November 1979, the increase was on the order of 25 percent. In comparison, North Korea has raised the prices of corn and rice by nearly 4,000 percent. In the absence of huge supply responses, the result will be an enormous jump in the price level and possibly even hyperinflation.

Moreover, when China began its reforms in 1979, more than 70 percent of the population was in the agricultural sector. (The same held true for Vietnam when it began reforming the following decade.) In contrast, North Korea has perhaps half that share employed in agriculture. This has two profound implications: first, the population share, which is directly benefiting from the increase in producer prices for agricultural goods, is roughly half as big as in China and Vietnam. This means that reform in North Korea is less likely to be what economists call Pareto-improving (in other words a change in which no one is made worse off) than the cases of China or Vietnam. Instead, reform in North Korea is more likely to create losers and with them the possibility of unrest. Second, the relatively smaller size of the agricultural sector suggests that the positive supply response will not be as great in the North Korean case as compared to China or Vietnam either. Again, this increases the likelihood of reform creating losers and unrest.

In the short run, the initial jump in the price level is usually accompanied by an increase in economic activity, as households and enterprises mistake increases in the overall price level for changes in relative prices. This is likely to be particularly acute in North Korea, where many households and enterprises can be expected to be relatively naïve about market economics, and where significant alterations in the structure of relative prices will be coincident with the rapid increase in the price level. So in the short run, there may be an increase in economic activity.

In the longer run however, once households and enterprises begin to distinguish more clearly between changes in relative and absolute prices, it will become apparent that some parts of the population have experienced real increases in income and wealth, while others have experienced real deteriorations. The North Koreans have not announced any mechanism for periodically adjusting prices, so in all likelihood, disequilibria, possibly severe, will develop over time. Access to foreign currency may act as insurance against inflation, and in fact, the black market value of the North Korean won has dropped approximately 50 percent since the reforms were announced.

Those with access to foreign exchange such as senior party officials will be relatively insulated from this phenomenon. Agricultural workers may benefit from “automatic” pay increases as the price of grain rises, but salaried workers without access to foreign exchange will fall behind. In other words, the process of marketization and inflation will contribute to the exacerbation of existing social differences in North Korea. Given how stressed a society North Korea has become, the implications for “losers” could be quite severe. It would not be at all surprising to observe a significant increase in mortality rates.

Make no mistake about it: North Korea has moved from the realm of elite, to the realm of mass politics. Unlike the diplomatic initiatives of the past several years, these developments will affect the entire population, not just a few elites. And while there is a consensus that marketization is a necessary component of economic revitalization, the inflationary part of the package would appear to be both unnecessary and destructive. (If one wanted to increase the relative wages of coal miners by 40 percent, one could simply give them a 40 percent raise–one does not need to increase the overall price level by a factor of 10, and the nominal wages of coal miners a factor of 14 to effect the same real wage increase.)

So why do it? There are at least three possible explanations. The first, as alluded to above, is the most benign: by creating inflation, the government hopes to provide a short-run kick-start to the economy, the long-run implications be damned. (From the standpoint of North Korean policymakers, Keynes’ aphorism, “in the long run we are all dead” may apply with a rather short time horizon.) Given the extremely low levels of capacity utilization in the North Korean economy, this argument has a certain surface plausibility. Yet the problems of the North Korean economy run far, far deeper than underutilized resources. In large part the economy is geared to produce goods (televisions and radios without tuners, to cite one example, or Scud missiles, to give another) for which there is only limited demand. Unless there is a significant reorientation in the composition of output, it is unlikely that inflation alone will generate a sizeable supply response. Even agriculture is problematic in this regard: North Korean agriculture is highly dependent on industrial inputs (chemical fertilizers and agricultural chemicals, for example) and agriculture could be disrupted if the farmers find themselves getting squeezed on the input side.

A second possibility is that the inflation policy is intentional, and is a product of Kim Jong-il’s reputed antipathy toward private economic activity beyond state control. One effect of inflation is to reduce the value of existing won holdings. (For example, if the price level increases by a factor of 10, the real value of existing won holdings is literally decimated.) Historically, state-administered inflations and their cousins, currency reforms, have been used by socialist governments to wipe out currency “overhangs” (excess monetary stock claims on goods in circulation), more specifically to target black marketers and others engaged in economic activity outside state strictures, who hold large stocks of the domestic currency. (In a currency reform, residents are literally required to turn in their existing holdings—subject to a ceiling, of course—for newly issued notes.) In July it was announced that the blue won (Korean People’s Won) foreign exchange certificates would be replaced by the normal brown won, though it is unclear if these are convertible into foreign currency. In the case of North Korea, the episode that is now unfolding will be the fourth such one in the country’s five-decade history.

The hypothesis has the strength of linking what appears to be a gratuitous economic policy to politics-Kim Jong-il not only rewards favored constituencies by providing them with real income increases and by going the inflation/currency reform route, but he also punishes his enemies. This line of reasoning is not purely speculative: it has been reported that one of the motivations behind unifying prices in the PDS and farmers’ markets has been to reduce the need of consumers to visit farmers’ markets, and to “assist in the prevention of “illegal sales activities” which took place when the price in the farmers’ market was much higher than the state price” (CanKor, 9 August 2002). A number of unconfirmed reports indicate that the government has placed a price ceiling on staple goods in the farmers’ markets as an anti-inflationary device. The increase in the procurement price for grain has reportedly been motivated, at least in part, to counter the supply response of the farmers, who were diverting acreage away from grain to tobacco, and using grain to produce liquor for sale.

The problem with this explanation is that having gone through this experience several times in the past, North Korean traders are not gullible: they quickly get out of won in favor of dollars, yen, and yuan. Indeed, even North Koreans working on cooperative farms reportedly prefer trinkets as a store of value to the local currency. As a consequence, this blow aimed at traders, may fall more squarely on the North Korean masses, especially those in regions and occupations in which opportunities to obtain foreign currencies are limited.

As an economist I am trained to assume rationality, and it is only with reluctance that I propose arguments that presume ignorance. But my personal experience in China suggests one more possible explanation for the North Korean policy. Demand and supply are not quantities or points—they are schedules indicating quantities as a function of prices. Market-determined prices are thus a signal of scarcity value reflecting underlying demand and supply. Conversations with Chinese officials in the early to mid-1980s, during the first stage of the marketizing reforms, however, revealed that fundamental misunderstanding of the nature of markets was widespread, especially among older officials who had spent many years in a planned economy.

The North Koreans have indicated that they are trying to unify (or at least reduce the differences between) state prices and those observed in the farmers’ markets. In a press report, one unnamed official laid out the logic of the price reform: the administered price of rice would be raised to the farmers’ market price, but since no one could afford rice at the market price, everyone’s nominal wages would be increased commensurately. What this official did not seem to grasp was that the amount of won in circulation was instantly increased by a factor of 10 due to the wage increase, unless there was an immediate supply-response, then the government had effectively caused a 900 percent jump in the price level.

Again, political considerations increase the plausibility of this argument. By all reports, the economic policy changes being undertaken in North Korea are being devised by a small number of senior officials. Moreover, North Korea has a political system in which the political space of discussion and dissent is highly constricted, and the penalties for being on the wrong side of a political dispute can be quite severe. So while the logic of too many won chasing too few goods would seem elementary to those of us raised in market economies, under the circumstances that exist in North Korea, the possibility that economic decisions are being made by people who do not grasp the implications of their actions (or are afraid to voice their reservations and instead engage in preference falsification if they do) should not be dismissed too hastily.

Special Economic Zones

The third component of the North Korean economic policy change is the formation of special economic zones of various sorts. The first such zone was established in the Rajin-Sonbong region in the extreme northeast of the country in the mid-1980s. It has proved to be a failure for a variety of reasons including its geographic isolation, poor infrastructure, onerous rules, and interference in enterprise management by party officials. The one major investment has been the establishment of a combination hotel/casino/bank. Given the obvious scope for illicit activity associated with such a horizontally integrated endeavor, the result has been less Hong Kong than Macau North.

The 1998 agreement between North Korea and Hyundai that established the Mt. Kumgang tourist venture also provided for the establishment of an industrial park to be managed and operated by Hyundai. While the tourism project was obviously the centerpiece of the agreement, from the standpoint of revitalizing the North Korean economy, the establishment of the industrial park, which would permit South Korean small- and medium-sized enterprises (SMEs) to invest in the North with Hyundai’s implicit protection, was actually more important. In the long run, South Korean SMEs will be a natural source of investment and transfer of appropriate technology to the North. However, in the absence of physical or legal infrastructure, they are unlikely to invest. The Hyundai-sponsored park would in effect address both issues. (The chaebols, because of their size and political connections, would not be so reliant on formal rules—they could always go to the South Korean government if they encountered trouble in the North.) The subsequent signing of four economic cooperation agreements between the North and South on issues such as taxation and foreign exchange transactions could be regarded as providing the legal infrastructure for economic activity by the politically noninfluential SMEs.

The North Korean government and the South Korean firm then negotiated for 18 months over the location of the zone, with the North Koreans wanting it in Sinuiju, a city of some symbolic political importance in the northwest of the country on the Chinese border, and Hyundai wanting to locate the park in the Haeju district, more easily accessible to South Korea. In the end, it was agreed that the park would be located in Kaesong-a decision that was hailed at the time as reflecting an increased emphasis on economic rationality in North Korea.

The industrial park at Kaesong has not fulfilled its promise, however: Hyundai’s dissolution forced the South Korean parastatal KOLAND to take over the project, and the North Koreans inexplicably failed to open the necessary transportation links to South Korea on their side of the demilitarized zone (DMZ). Hence the September 2002 initiation of activity on the northern side of the DMZ could be an important step in the take-off of the Kaesong industrial park.

In September 2002 the North Korean government announced the establishment of a special administrative region (SAR) at Sinuiju. In certain respects the location of the new zone was not surprising: the North Koreans had been talking about doing something in the Sinuiju area since 1998. Yet in other respects the announcement was extraordinary. The North Koreans announced that the zone would exist completely outside North Korea’s usual legal structures; that it would have its own flag and issue its own passports; and that land could be leased for fifty years.

To top it off, the North Koreans announced that the SAR would be run by Yang Bin, a somewhat shady Chinese—born entrepreneur with Dutch citizenship who was under investigation for tax evasion in China, and had reportedly fled to North Korea-though he does not speak Korean—during two previous investigations. (Among his various business interests, Yang operates a Dutch-style village in Shenyang complete with a windmill and imitations of Amsterdam buildings. Kim Jong-il, who knows a thing or two about fantasylands, has visited it himself.) At the time of Yang’s appointment, trading in shares of his firm, Euro-Asia Agriculture Holdings, had been suspended on the Hong Kong stock exchange after crashing on the suspicion of fraud. When asked about Yang’s appointment, China’s Foreign Ministry spokesperson declined to endorse it. To paraphrase Senator Lloyd Bentsen’s memorable line from the 1988 US Vice Presidential debate, “Mr. Yang, you are no Tung Chee Hwa.” Indeed, Mr. Yang was subsequently arrested by Chinese authorities. Whether the zone will survive his arrest remains to be seen.

Assuming that these are mere growing pains, the question arises as to how important the Sinuiju SAR may prove to be. It should promote economic integration between North Korea and China, though one should keep in mind that China is a big place and that the most economically dynamic parts are in the southern coastal areas far from North Korea. But the North Korean economy is so far down that even integration with a comparative backwater like Dandong could be a boost.

More important is whether the SAR will generate any spillovers. In conventional terms this will depend on whether any lessons from the Sinuiju SAR experiment are generalized to the rest of the economy. (One ray of hope in recent events is the removal of the less than 50 percent foreign ownership ceiling in joint ventures.) More subtly the SAR might have a positive impact if internally it is regarded as giving Kim Jong-il’s unimpeachable imprimatur to the reform process. Bureaucrats and factory managers who have been reluctant to get ahead of the leadership may take this as a sign that change is safe. Conversely, by taking the SAR completely outside of the normal North Korean governing structures, Kim Jong-il can in effect end-run the party and the bureaucracy, and manage the zone directly out of his office.

Uncle Junichiro…

Meanwhile, as exciting as the establishment of the Sinuiju SAR might have been, its long-run significance is probably less than that of an event that had occurred the previous week—a meeting in Pyongyang between Kim Jong-il and Koizumi Junichiro, a manifestation of the fourth component of the economic plan, passing the hat.

At the first-ever meeting between the heads of government of Japan and North Korea, Kim stunned the world by baldly admitting that North Korean agents had kidnapped 12 Japanese citizens and that most of the abductees were dead. Each of the leaders then expressed regrets for their countries’ respective historical sins and agreed to pursue diplomatic normalization. It is expected that normalization will be accompanied by a large financial transfer from Japan to North Korea in the form of grants, subsidized loans, and trade credits. Japanese officials have not denied formulas reported in the press that would put the total value of a multiyear package at approximately $10 billion, despite the shaky state of Japanese public finances. Taking inflation, changes in the value of the yen, differences in population size, and other factors into account, this sum would be in the ballpark of the transfer that Japan made to South Korea in 1965 when the two countries normalized relations. Given the puny size of the North Korean economy, this is a gigantic sum. The critical issue for North Korea is whether these talks will proceed rapidly enough to generate aid inflows before the dislocations of marketization begin to bite. Given the Japanese public’s revulsion at the disclosure of the probable murders of some of the abductees, the process of normalization may be more protracted than either the North Korean or Japanese governments expected.

In connection with this process, there are rumors that the North Koreans intend to establish yet another special economic zone on the east coast, to be oriented toward Japan. Discounting the failed zone at Rajin-Sonbong, this would give the North Koreans three special economic enclaves, one oriented toward South Korea, one toward China, and one toward Japan, diversifying their portfolios so to speak. Again, given the centrality of politics to North Korean thinking, they may well envision playing the three off against each other. In the long run, however, it is integration with South Korea that will be critical to the development of the North Korean economy.

…and Uncle Sam

The Koizumi visit amounted to a kick in the pants to the Bush Administration. It brought to a head the disagreement between the hawks and the moderates in Washington. Assistant Secretary of State James Kelly was sent to Pyongyang with greater alacrity than he otherwise would have had. With its two allies in Northeast Asia moving forward with engagement, the “Axis of Evil” characterization will become increasingly difficult to sustain, and the United States will find its options more constrained.

For example, North Korea’s membership on the list of state sponsors of terrorism prevents the United States from supporting the DPRK for membership in international financial institutions such as the International Monetary Fund, World Bank, or Asian Development Bank. The North Koreans have fulfilled most of the terms set out by the Clinton Administration to secure their removal from the list. A major sticking point has been third-party claims by Japan associated with the Japanese Red Army hijackers and the abductees. If the hijackers are returned to Japan and the North Korean and Japanese governments resolve the abductee issue as now seems likely in the near future, a major obstacle to North Korea getting off the list of state sponsors of terror will have been removed. While it is quite possible that the Bush Administration will insist on keeping them on the list and barring their entry into the international financial institutions, this position will be increasingly hard to sustain in the face of South Korean and Japanese objections.

At the same time, the transfer from Japan to North Korea is the single biggest financial claim that North Korea maintains on the international system and dwarfs anything it could hope to get from the multilateral development banks. Unlike the sorts of carrots that the United States might offer, it also contains an element of irreversibility, and no matter how well conditioned the loans, money is at least partly fungible, raising the understandable worry in Washington that the Japanese settlement could be used for military modernization. The apparent lack of consultation between the United States and Japan in the run-up to the meeting has added to Washington’s concerns.

Conclusions

In the end, to understand the meaning of what has occurred in the last several months, one has to make some kind of assessment of the motivations behind North Korea’s policy changes. One argument put forward by some North Korea-watchers is that Kim Jong-il has long understood that the North Korean system is irretrievably broken, but that it has taken a long time for him to consolidate power and implement these far-reaching changes. This is hard to believe. Kim Jong-il was reputedly running the country on a day-to-day basis for ten years before his father’s death eight years ago. This means he has in effect been running the country for 18 years and was the uncontested supreme leader for the last eight. In a political system as hierarchical as North Korea’s, it is difficult to accept that it has taken him this long to consolidate his position.

Indeed, the opposite interpretation would seem more plausible, namely, that Kim Jong-il has reluctantly concluded that the old methods are inadequate to revive the economy and out of political necessity is embracing marketization, inflation, and the former colonial master in a desperate bid to revitalize a moribund system. If this interpretation is correct, then we should expect hesitancy in the implementation of reforms, and a strong reliance on the international social safety net supplied by the rest of the world. In certain respects the plans put forward thus far appear to be ill-conceived, but a combination of marginal increases in economic activity and international aid inflows may put enough goods on the shelves to keep the population pacified, at least in the short run. Ten billion dollars can buy a lot of transistor radios.

However, the initiatives undertaken in the last several months are qualitatively different from the diplomatic initiatives that the North Koreans undertook over the last several years. Marketization and inflation alter economic, political, and social relations on the ground, and raise far higher stakes internally. While the upside potential may be great, failure could mean the end of the regime. The train has left the station, but where it is headed and if it will derail are open questions—even for the conductor.

Table 1: Price Increases

Product   Reported Price Increase (percent)

Rice   4,000
Corn   3,700
Pork   700

Diesel fuel   3,700
Electricity   5,900

Apartment rent   2,400
Subway ticket   900

Sources: Press reports, private correspondence.

Dow Jones Newwire

PYONGYANG — At the foreign exchange counter at the self-proclaimed ‘deluxe’ Koryo Hotel, an electronic screen posts the daily rate of the North Korean won against various international currencies.

Quotes for a dozen or so currency pairs light up in red digital numbers, one after the other.

One rate that doesn’t shift too much is the dollar-won, which generally hovers at or around 2.16 won to the dollar. Speculation has it that the government has fixed the won’s rate against the dollar around that level to commemorate the February 16 birthday of Kim Jong-il, the country’s semi-divine leader.

Sounds strange? The fact is, in this quasi-theocratic country, if it looks like adulation, it probably is. This is, after all, the nation that holds a weeklong exhibition (in mid-February, of course) to admire the Kimjongilia, the national flower.

In any case, whether there is a peg at 2.16 or not, North Korea’s currency bears little relation to economic fundamentals.

Indeed in the Rajin-Sonbong trade zone in the north of the country, where the government has experimented with a free market rate, and along the Chinese borders where there is an active black market, the rate of the won tends to be more like 200 won to the dollar, analysts say. That’s a difference of a hundred fold – making the North Korean won one of the most distorted currencies in the world.

“The pricing of the won doesn’t have any particular relationship to any economic cost concept,” explains Bradley Babson, a senior advisor to the World Bank who specializes in North Korea.

That may have made little difference in the Soviet-style planned economy that has characterized this country’s economy to date. However, as the country tentatively opens its doors to international trade and investment and toys with the idea of using at least some elements of a market economy, currency reform will become vital, analysts say.

Ideological Aversion to Money

Unfortunately, other than the experiment in Rajin-Sonbong, there is little sign the country’s Communist leaders are prepared to take this step yet.

Monetary reform North Korean-style, the latest round of which took place in the early 1990s, has normally been focused on confiscating funds from overly rich entrepreneurs – not exactly the kind of adjustment the IMF would endorse.

At issue is the official Communist ideology which views money as a dirty instrument of capitalism. As such, its role within the economy should be kept to a minimum.

As Deok Ryong Yoon, an economist at the Korea Institute for International Economic Policy in Seoul, explains, until 1990, the North Korean won served not as money at all, but purely as an accounting unit.

North Korean residents didn’t need money because all their needs were met by the state distribution system – one of the most complete anywhere in the Communist world.

That is now changing. “Nowadays people use money and monetization is quite advanced,” says Yoon.

What doesn’t seem to be changing, however, is the government’s attitude toward money. “The regime does not admit the reality,” he says.

That means a complete absence of an “institutional framework” to manage money in the economy, leading to inflation rates of around 700%, according to Yoon’s estimates.

True, there is formally a central bank. But western economists who have met with officials from the Choson Central Bank describe them as meek bureaucrats who have little knowledge of even the most basic economic principles.

The result has been an increasing marginalization of the North Korean won – also nicknamed the ‘brown’ won for its brown and grubby appearance – in the economy. North Koreans resort to barter to meet their basic consumption needs – and increasingly just do transactions in hard currency, such as U.S. dollars, Chinese yuan or even Japanese yen.

Worthless Currency

The same is true of foreign investors. North Korea has a ‘foreign exchange certificate’ system – the same type used in China until 1994. Under this system, foreigners exchange dollars not for local currency but for special purple and blue currency notes.

If as a tourist you change money here, such special notes is what you’ll get. But it’s hard to find anywhere to spend them – as hard currency is demanded for most transactions.

“Basically it’s all done in U.S. dollars,” says Roger Barrett, chief representative of a Beijing-based business group that helps foreign businesses interested in investing in North Korea.

“Hard currency is the export focus, and you get your money back in hard currency,” he says.

The large South Korean projects in North Korea, such as Hyundai’s tourist cruises to Mt. Kumgang, have also been structured in U.S. dollars, according to Yoon.

Pending a major reform of the North Korean currency and pricing system, this tendency to use the dollar in any commercial transaction is likely to continue, analysts say.

In the meantime, even investors used to the most exotic instruments rule out the prospects of the North Korean won as a currency play.

“No we can’t really do anything with it,” says Jerome Booth, head of research at Ashmore Investment Management in London. “I’ve never heard of anyone trying to do anything.”

An economist who travels regularly to North Korea was even more scathing. “I don’t think this currency is worth anything anywhere,” he said.

If either project is built, then, it would probably come as foreign aid, probably in exchange for once again putting North Korea’s nuclear weapons program back under international inspection and control. After a six-month break in talks over the weapons program, American diplomats were touring Northeast Asia over the weekend trying to restart the negotiations.

Yevgeny Afanasiev, a senior Russian diplomat, said at the forum that his country “will do our utmost” to promote the two projects. “They do not have to be part of a package, they could be separate,” Mr. Afanasiev said. “But think of private investors, think of the high political risk – would you invest?”

Financing could come as part of a wider package that would gain North Korea entry into the World Bank and the Asian Development Bank. Or the money might be put up by South Korea, which would stand to benefit both directly and indirectly.

“The Russians basically believe that South Koreans will pay for it,” said Yonghun Jung, a Korean executive at the Asia Pacific Energy Research Center in Tokyo.

But many South Korean businesspeople see North Korea as an unreliable money pit.

Korea Gas, favors bringing Russian gas to South Korea through China and an underwater pipeline, bypassing North Korea and denying it any control over the supply.