by
Wonhyuk Lim
[Korea Development Institute]
posted November 15, 2006
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Article : |
*The original draft of this paper was presented at the Seventeenth
U.S.-Korea Academic Symposium Dynamic Forces on the Korean Peninsula:
Strategic & Economic Implications, sponsored by the Korea Economic Institute (KEI),
Korea Institute for International Economic Policy (KIEP),
and Preventive Defense Project, Harvard University, September 25-27, 2006,
Harvard University, John F. Kennedy School of Government, Cambridge, Massachusetts.
For the full-length version of this essay, please visit the IFES Forum
at ifes.kyungnam.ac.kr.
Inter-Korean Economic Cooperation at a Crossroads
Economic relations between North and South Korea broke
major new ground in 2005. Inter-Korean trade increased by more
than 50 percent over the previous year and exceeded $1 billion
for the first time. After many years of struggle, Hyundai's Mt.
Kumgang tourism project turned in an operating profit. The
Kaesong Industrial Complex, located just north of the
demilitarized zone (DMZ), began churning out goods in mass
quantities, showing what North and South Korea could do if they
work together. Last but not least, the September 19 joint
statement of principles raised hope that the six-party process
would resolve the long-running nuclear crisis on the Korean
peninsula and enhance peace and security in Northeast Asia.
These positive developments fueled speculation that, after
several false starts over the past decade, inter-Korean economic
relations had finally entered a new phase of sustained growth.
However, such optimism had fizzled out by the summer of
2006. Almost immediately after the release of the joint
statement of principles, the U.S. and North Korea issued polar-
opposite interpretations of the document, particularly with
regard to the sequencing of steps to be taken in the course of
resolving the nuclear crisis.[1] U.S. financial regulatory
actions against North Korea, implemented just before the
September 19 joint statement, further complicated the situation.
Whereas Washington insisted that these measures had everything to
do with law enforcement and nothing to do with the six-party
talks, Pyongyang saw them as yet another evidence of America's
hostile policy toward North Korea.
With the hardening of U.S. policy toward North Korea,
inter-Korean economic cooperation came under greater scrutiny.
Whereas South Korea argued that inter-Korean economic cooperation
would facilitate reform in North Korea, the U.S. feared that it
would only sustain the Kim Jong Il regime while producing minimal
changes in its behavior. The friction between South Korea and
the U.S. cast a dark shadow over the prospects of inter-Korean
economic relations.[2]
To make matters worse, North Korea increasingly called for
the resolution of "the fundamental issues" blocking progress in
inter-Korean relations -- namely, the lifting of South Korea's
ban on visits to the Kim Il Sung mausoleum, redrawing of the
Northern Limit Line (NLL) in the Yellow Sea, abolition of the
National Security Law, and discontinuation of South Korea's joint
military exercises with the U.S. In fact, Pyongyang abruptly
canceled an inter-Korean train run scheduled for May 2006 when it
could not make any progress on the NLL issue contrary to its
expectations. North Korea's missile launch on America's
Independence Day further poisoned the atmosphere for inter-Korean
economic cooperation. In response to the missile launch, the
South went so far as to stop food and fertilizer aid to the North,
except for a reduced emergency aid shipment after a flood in the
North. Finally, North Korea's nuclear test on October 9 shook up
the very foundation of inter-Korean economic relations and
prompted serious questions about the possible transfer of
proceeds from cooperation projects to North Korea's weapons
programs. In particular, the adoption of the United Nations
Security Council Resolution 1718 on October 14 led to increasing
demand for transparency.
In sum, although inter-Korean economic cooperation seems
more commercially viable than ever before, its political
foundation has considerably weakened since September 2005. With
the six-party process going nowhere and inter-Korean relations at
one of the lowest points in recent memory, there is increasing
concern about the future of economic cooperation on the Korean
peninsula. This paper looks at the development of inter-Korean
economic relations since the late 1980s and draws policy
implications for the future.
1. Overview of Inter-Korean Trade
In South Korea, according to the Law on South-North
Exchanges and Cooperation (1990) and the Special Law on
Implementation of the World Trade Organization Agreement (1995),
inter-Korean economic cooperation is regarded as an "intra-
national transaction." In fact, the Law on South-North Exchanges
and Cooperation uses terms such as "carry-in" and "carry-out"
instead of "import" and "export," to signify the internality of
trade between South and North Korea, and explicitly exempts the
application of the Tariff Law to goods "carried in" from North
Korea. Article 5 of the Special Law stipulates that "trade
between South Korea and North Korea constitutes internal trading
within a nation and as such shall not be regarded as that between
countries."[3]
With the Cold War coming to an end, North and South Korea
signed the Inter-Korean Basic Agreement in 1991 and provided for
the first time an institutional framework for inter-Korean
economic exchanges. The total volume of inter-Korean trade
reached $100 million in 1991 and soared to nearly $200 million in
1992, as processing-on-commission (POC) trade began to expand
rapidly. The first nuclear crisis of 1993-1994, however, put a
brake on this trend, as South Korea pursued a strategy of linking
inter-Korean economic cooperation with the resolution of the
nuclear crisis. Although the Geneva Agreed Framework of 1994
provided a renewed impetus, the next four years saw fluctuations
in the volume of inter-Korean trade as North Korea's food crisis
and South Korea's financial crisis buffeted the two economies.
South Korea's adoption of the Sunshine Policy in 1998 and
recovery from the financial crisis in 1999 began to clear these
obstacles. The Kim Dae Jung government made clear that it would
neither condone the North's armed aggression nor seek unification
by absorption, but instead focus on promoting inter-Korean
reconciliation and cooperation. The South also gave a green
light to companies such as Hyundai to undertake investment
projects in the North and began to provide a significant amount
of humanitarian aid to the North. The inter-Korean summit of
June 2000 marked a watershed as the two sides agreed to push
ahead with cooperation projects at a governmental level. The
total volume of inter-Korean trade reached $400 million in 2000
and exceeded $600 million in 2002. By the end of 2002, three
major inter-Korean cooperation projects (Mt. Kumgang tourism,
Kaesong Industrial Complex, and linking of the railroads) had
begun to make significant progress.
3. Significance of Inter-Korean Trade
(1) South Korea's Perspective
Little more than $1 billion in 2005, inter-Korean trade
amounts to a miniscule 0.19 percent of South Korea's external
trade with the rest of the world. However, this metric does not
do justice to the significance of inter-Korean trade for South
Korea. Inter-Korean economic cooperation has great significance
for the integration and unification of the Korean peninsula for
the longer term. In fact, there are three major rationales for
inter-Korean economic cooperation, each of which is important for
unification.
First, inter-Korean economic cooperation would help North
Korea to see a way out its current predicament as "a rogue state"
or "a criminal regime."[4] Through economic exchanges, North
Korea would be able to earn money the old-fashioned way rather
than through questionable transactions involving counterfeiting,
narcotics, or weapons. Also, by helping North Korea to get
accustomed to market principles, inter-Korean economic
cooperation would have the effect of facilitating and
consolidating North Korea's economic reform. It is a critical
component of South Korea's engagement policy, which is based on
the principle of "change through rapprochement."[5]
Second, inter-Korean trade would help South Korea to
undertake industrial restructuring in a less painful manner.
South Korean firms in the labor-intensive manufacturing sector
face increasing competition from China and other late-developing
countries, and the "hollowing out" of the economy caused by
outward foreign direct investment (FDI) is increasingly becoming
a concern. Given North Korea's willingness to experiment with
special economic zones, these companies may find investment in
North Korea to be a viable alternative, with positive linkage
effects in South Korea.
Third, inter-Korean economic cooperation would have the
geopolitical significance of counterbalancing China's increasing
influence in North Korea. South Korea has a strong incentive to
hedge against China's "non-peaceful rise" and harbors strategic
anxiety regarding China's increasing influence on North Korea.[6]
In fact, in South Korea, there is a growing concern that North
Korea might become "China's fourth Northeastern province" if
China's economic and geopolitical influence on North Korea
continues to rise. As a result, inter-Korean trade is
increasingly regarded as a means of preventing North Korea from
becoming a Chinese satellite.
(2) North Korea's Perspective
For North Korea, inter-Korean trade represents a
significant part of its overall trade with the outside world.
Between 2000 and 2005, South Korea's share in North Korea's total
trade increased from approximately 18 percent to 26 percent. By
comparison, China's share in North Korea's total trade increased
from 20 percent to 39 percent during the same period. The
expansion of North Korea's trade with South Korea and China had a
very positive effect on the North Korean economy. According to
one estimate, between 1999 and 2003, North Korea's economic
growth due to its expanding commercial and non-commercial
transactions with South Korea amounted to 2.3 percent per year.
North Korea's annual economic growth stemming from its expanding
trade with the rest of the world was 2.4 percent per year.[7]
Inter-Korean trade also helps to alleviate the balance-of-
payments problem for North Korea. If non-commercial transactions
(mostly humanitarian aid) and the flows of goods associated with
economic cooperation projects (mostly equipment and construction
materials to be used by South Korean companies) are excluded,
North Korea is actually running a surplus in its trade with South
Korea.[8] In 2005, the North recorded a surplus of $221 million
in its general and POC trade with the South.[9] North Korea also
earns hard currency by providing services (e.g., tourism) and
granting exclusive rights to development projects in North Korea.
In addition to playing a significant role in North Korea's
economic growth and alleviating its balance-of-payments problem,
inter-Korean trade is important for North Korea as a means of
facilitating economic reform. The evolution of North Korea's
economic policy over the past two decades seems to indicate that
Pyongyang has become more favorably disposed toward economic
reform and opening, in large part as a result of the famine in
the 1990s, and inter-Korean economic cooperation is likely to be
an important element of its new policy package.[10] After a
decade of economic crisis in North Korea, Pyongyang realized that
only the infusion of external capital would put economic growth
on a more stable trajectory. While it is still concerned about
regime stability, Pyongyang has made serious efforts to ensure
commercial viability for companies in Kaesong. This is seen in
the fact that wage, tax, and land lease rates at Kaesong were set
at competitive levels with China's. Although Kaesong as it
currently stands is an export enclave, it is likely to have
spillover effects on the rest of North Korea over time as in the
case of special economic zones in China.[11]
3. Policy Dilemmas
(1) A Big Bang Approach vs. Gradualism
In pursuing an engagement policy, one of the earliest
policy questions South Korea faced was how best to promote inter-
Korean economic cooperation. There were basically two schools of
thought on this issue. One school urged gradualism. They
believed that pursuing a series of economically sound projects in
labor-intensive sectors, undertaken primarily by small and
medium-sized enterprises, would educate North Korea about market
principles and ensure the long-term sustainability of inter-
Korean economic cooperation. The other school called for a big
bang approach. They believed that inter-Korean economic
cooperation would go nowhere unless it received a clear
endorsement from North Korea's top leadership. They also noted
that SMEs would have limited success due to poor physical
infrastructure in North Korea, unless the South Korean government
or large companies led the way by providing electricity, water,
communication links, and other essential business supports.
Both approaches proved wanting in practice. SMEs that
ventured into North Korea on their own were exposed to a great
deal of risks, and most of them failed to undertake any
significant and viable investment projects in North Korea. Large
companies that paid inadequate attention to the commercial side
of business also fared poorly. Hyundai may be the most notorious
example in this regard. In 1998, the company secured Kim Jong
Il's endorsement for inter-Korean economic cooperation by
launching its ambitious Mt. Kumgang tourism project, promising to
pay out $942 million over 75 months. However, Hyundai's big bang
approach could not be sustained when the cash flow from its
projects failed to meet expectations.
Subsequently, it became clear that successful inter-Korean
economic cooperation would have to combine the desirable features
of both the gradual and big bang approaches. While securing the
endorsement of North Korea's top leadership and providing for
necessary infrastructure, business projects also had to have
commercial viability. The evolution of tourism at Mt. Kumgang
shows how this new principle was applied in practice. When
Hyundai could not meet the payment schedule for $942 million,
Pyongyang initially balked at renegotiating the terms of the
contract. However, Pyongyang came to realize that playing
brinksmanship with a company on the verge of bankruptcy would not
work and subsequently agreed to make the tourism project more
viable. The two sides agreed on a flexible scheme by which North
Korea would charge a park entrance fee per tourist starting in
September 2001. Also, to make the tourism project commercially
profitable, North Korea agreed to open a ground route to Mt.
Kumgang. As a result of these changes, the number of tourists
visiting Mt. Kumgang increased and the tourism project turned in
an operating profit of 5 billion won in 2005.
In short, as demonstrated by the examples of the Mt.
Kumgang project and Kaesong Industrial Complex, inter-Korean
economic cooperation has become much more systematic and market-
oriented. Drawing lessons from the failure of exclusively
gradual or big bang approaches, North and South Korea are seeking
to make inter-Korean economic cooperation more commercially
viable and sustainable.
(2) Economic-Security Linkage
Whether to link inter-Korean economic cooperation to
security issues is a question that has haunted South Korean
policymakers since the nuclear crisis of 1993-4. Many argued
that continuing to engage in inter-Korean economic cooperation in
the face of North Korea's provocative behavior would send the
wrong signal: North Korea would think it could get away with such
behavior, and the U.S. and other countries would conclude that
South Korea does not take North Korea's threat seriously. Others
argued that while economic cooperation could not be completely
de-linked from political and security issues, a tight linkage
strategy would shut down important channels of communication with
North Korea and run the risk of making South Korea a helpless
bystander.
The Kim Dae Jung government adopted the principle of
"separating politics from commerce." It tried to contain North
Korea's threat through deterrence and arms control under the
principle of mutual threat reduction, and also promote internal
changes in North Korea through broad economic engagement.
Following this parallel-track strategy, the Kim Dae Jung
government pushed for within-issue linkage rather than cross-
issue linkage. In other words, it linked humanitarian aid with
humanitarian issues, economic issues with economic issues, and
security with security issues, but not economic issues with
security issues. Although there was little progress in official
inter-Korean dialogue for the first two years of the Kim Dae Jung
government, companies like Hyundai and various nongovernmental
organizations (NGOs) were able to make much headway in economic
cooperation and humanitarian assistance. Inter-Korean
confidence-building through such people-to-people interaction
helped to create an environment conducive to political
reconciliation at the governmental level. Under the parallel-
track strategy, inter-Korean economic cooperation had outpaced
political reconciliation, giving economic actors an incentive to
serve as political mediators.
The parallel-track strategy was effective as long as the
U.S. was willing to engage in serious negotiations with North
Korea regarding its nuclear and missile programs. When the North
Koreans failed to secure the kind of political relationship they
had expected from the U.S. under the Agreed Framework of 1994,
they complained bitterly even as they maintained the freeze on
their plutonium program. In 1998, however, North Korea launched
a long-range test missile and also procured from Pakistan some
equipment that could be used for enriching uranium.[12] The
Clinton administration opted for a "more-for-more" approach.
Through the Perry process in 1998-9, the U.S. and South Korea
essentially agreed on a division of labor by which the U.S. would
address security issues through direct negotiations with North
Korea and South Korea would promote internal changes in North
Korea through economic engagement. Recognizing the danger of
letting the Agreed Framework unravel, the U.S. made a more
decisive move toward normalization with North Korea in exchange
for more comprehensive restrictions on North Korea's missile and
nuclear programs.
At the end of 2000, the U.S. and North Korea appeared very
close to concluding a missile deal and moving toward full
normalization, but the Bush administration adopted a completely
different approach in March 2001 -- more than a year before the
emergence of conclusive evidence on North Korea's attempt to
construct a uranium enrichment program. In October 2002, the
Bush administration used this evidence to press North Korea to
come clean and subsequently stopped heavy fuel oil deliveries,
essentially scrapping the Agreed Framework. Predictably, North
Korea responded by restarting its plutonium program.
As the Bush administration put more emphasis on regime
change than arms control as the central objective of its North
Korea policy, the division of labor between the U.S. and South
Korea had begun to break down. When the second nuclear crisis
erupted in October 2002, South Korea made serious efforts to
contribute to the resolution of the crisis instead of severely
reducing economic exchanges with North Korea. However, with the
six-party talks in a holding pattern and tension on the Korean
peninsula on the rise since September 2005, South Korea's
parallel-track strategy has been increasingly coming under attack.
4. Conclusion
Inter-Korean economic relations have come a long way since
South Korea's unilateral declaration to promote economic
engagement with North Korea on July 7, 1988. Inter-Korean trade
volume exceeded $1 billion for the first time in 2005, and major
cooperation projects such as the Mt. Kumgang tourism project and
Kaesong Industrial Complex are now more commercially viable than
ever before. Economic cooperation will not only facilitate North
Korea's market-oriented reform and South Korea's industrial
restructuring, but also promote Korean reunification.
Despite these positive developments in recent years,
however, the political foundation of inter-Korean economic
relations has considerably weakened since September 2005. In
particular, North Korea's missile launch and nuclear test have
prompted serious questions about the possible transfer of
proceeds from cooperation projects to North Korea's weapons
programs. Although a parallel-track strategy, separating
politics from commerce, has been an essential component of South
Korea's engagement policy, it is increasingly coming under attack.
For a parallel-track strategy to be successful, it is
imperative that comparable progress be made on parallel tracks.
In 1998-2000, South Korea was able to make a great deal of
progress in inter-Korean relations by taking advantage of the
synergy between economic cooperation and political reconciliation.
During the same period, the U.S. and South Korea also developed
an effective division of labor in dealing with North Korea, by
which the U.S. would contain North Korea's nuclear and missile
programs through arms control negotiations and South Korea would
promote internal changes in North Korea through economic
engagement. This division of labor broke down when the Bush
administration dropped arms control negotiations with North Korea.
With the U.S. and North Korea making little progress in security
areas, it has become increasingly difficult to defend inter-
Korean economic cooperation.
Just as it is not appeasement to talk to North Korea or any
other potential adversary, it is not appeasement to hire North
Korean workers and pay their wages. Instead of blaming economic
engagement that promotes internal changes in North Korea, it
would be far better to contain and reduce potential military
threats through arms control negotiations and reestablish the
policy synergy the U.S. and South Korea enjoyed in dealing with
North Korea.
NOTES:
[1] For a more comprehensive discussion, see Charles "Jack"
Pritchard, "Six-Party Talks Update: False Start or a Case for
Optimism?", presented at the conference on The Changing Korean
Peninsula and the Future of East Asia, co-hosted by the Center
for Northeast Asian Policy Studies (CNAPS), Brookings Institution,
and the Seoul Forum for International Affairs and JoongAng Ilbo,
December 1, 2005, Seoul. The paper is accessible at:
www.brookings.edu/fp/cnaps/events/20051201presentation.pdf.
[2] See, for instance, the op-ed exchange in the Wall Street
Journal between Jay Lefkowitz, U.S. Special Envoy on Human Rights
in North Korea (April 28, 2006), and Kwan-sei Lee, South Korea's
Assistant Minister of Unification (May 11, 2006).
[3] For a more detailed discussion on the domestic and
international legal status of inter-Korean economic cooperation,
see Dukgeun Ahn, "Legal Issues for Korea's 'Internal Trade' in
the WTO System," in Wonhyuk Lim and Ramon Torrent, eds.,
Multilateral and Regional Frameworks for Globalization: WTO and
Free Trade Agreements (Seoul: Korea Development Institute, 2005),
pp.362-376.
[4] It is one thing to state that Pyongyang has engaged in some
illicit activities, but it is quite another to imply that the
North Korean regime is criminal by nature?and beyond redemption.
For "the criminal state" view, see David L. Asher, "The North
Korean Criminal State, Its Ties to Organized Crime, and the
Possibility of WMD Proliferation," Nautilus Policy Forum Online
05-92A, November 15, 2005, accessible at:
www.nautilus.org/fora/security/0592Asher.html.
[5] On the basic premise of engagement policy, see Wonhyuk Lim,
"When in Doubt, Blame South Korea: The Politics of Food Aid to
North Korea," Nautilus Policy Forum Online 06-13A: February 16,
2006, accessible at: www.nautilus.org/fora/security/0613Lim.html.
[6] See, for instance, Myung-Chul Cho and Moon-Soo Yang, The
Increase of North Korea's Economic Dependence on China and Its
Implications for South Korea (Seoul: KIEP, 2005) [in Korean].
[7] See Young-Hoon Lee, "An Analysis of the Impact of North
Korea's External Trade and Inter-Korean Trade on North Korea's
Economic Growth" (Seoul: Bank of Korea, 2004) (in Korean).
[8] For instance, although North Korea appears to have run a
deficit of $582 million in its trade with China in 2005, the
figure shrinks to $346 million if China's crude oil exports,
provided on a loan basis, and aid to North Korea are excluded.
[9] Strictly speaking, this figure represents the difference
between the values of goods transported to and from South Korea,
and as such, overstates North Korea's surplus from its general
and POC trade with South Korea. The reason is that South Korean
companies typically transport goods between the North and the
South and charge shipping and handling costs, which are reflected
in the value of final goods.
[10] For a detailed discussion, see Wonhyuk Lim, "North Korea's
Economic Futures: Internal and External Dimensions," in Korea:
The East Asian Pivot, ed. by Jonathan D. Pollack (Newport, RI:
Naval War College Press, 2004), pp.171-195, also at
www.brookings.edu/fp/cnaps/events/lim_20051102.htm.
[11] See Ministry of Unification, "Answers to Frequently Asked
Questions about the Gaeseong (Kaesong) Industrial Complex," May
21, 2006.
[12] See Christopher O. Clary, "The A. Q. Khan Network: Causes
and Implications," Master's thesis (Monterey, California: Naval
Postgraduate School, December 2005), Chapter IV.
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