The Microeconomics of North–South Korean Cross-border Integration

Abstract

Economic integration between North and South Korea occurs through three modalities: traditional arm's-length trade and investment, processing on commission (POC) trade, and operations within the Kaesong Industrial Complex (KIC). In order, these three modalities are characterized by decreasing exposure of South Korean firms to North Korean policy and infrastructure. Through a survey of 200 South Korean firms operating in North Korea we find that these modalities of exchange matter greatly in terms of implied risk. For example, firms operating in the KIC are able to transact on significantly looser financial terms than those outside it. We find that direct and indirect South Korean public policy interventions influence these different modalities of exchange and thus impact entry, profitability, and sustainability of South Korean business activities in the North. In effect, the South Korean government has substituted relatively strong South Korean institutions for the relatively weak Northern ones in the KIC, thus socializing risk. As a result, the level and type of cross-border integration observed in the survey is very much a product of South Korean public policy.

Keywords:

• Economic integration
• transition
• institutions
• socialization of risk
• South Korea
• North Korea

JEL CLASSIFICATIONS :

• P3
• F15
• P33

Acknowledgement

The authors would like to thank Alex Melton for able research assistance. This work was supported by the Smith Richardson Foundation and Academy of Korean Studies grant AKS-2011-R39.

Notes

¹One respondent was found to be doing business exclusively with other South Korean firms at KIC and was subsequently excluded from the analysis, leaving an effective sample of 199 firms.

²A similar pattern of responses was obtained to a question asking when the respondent established a relationship with their most significant counterparty – most of these relationships were established after 2004.

³The SOE category itself is a bit problematic, encompassing entities and economic behaviors of at least three different types. The first are SOEs engaged in their traditional, legally sanctioned lines of business, presumably subject to extensive direct political control. The second are SOEs whose managers have exploited the company's legal status and resources to initiate non-traditional and in some cases completely unrelated (and even illicit) lines of business. Third, entrepreneurs affiliate with SOEs for political protection (Kim, 2007); the SOE may in fact be a shell for an effective joint venture partnership. Similar uncertainty about the true nature of the enterprise exists for other types of counterparties that are reported in the survey, such as North Korean government offices. Thus, while the plurality of counterparties are identified as SOEs, de facto privatization of exchange may be occurring under the mantle of the state, including through corruption, and it is possible that even the South Korean firms themselves do not know the true story behind their counterparts.

⁴These private connections do not appear to be systematic or reflect the activities of formal private associations. When asked if they were aware of non-official organizations such as commercial associations that might be helpful in doing business in North Korea, only 13% indicated awareness of such organizations, and only 16% of those (i.e., 2% of the whole sample of firms doing business in North Korea) had joined such an organization.

⁵The exception is the quitters, only one-third of which reported making a profit. Their responses to the other questions are similar to, if not somewhat more negative than, the overall group of respondents operating outside KIC.

⁶These were precisely the same four issues singled out by Chinese enterprises in an earlier survey (Haggard et al., 2012).

⁷One possible reason for the lower dispute rates for KIC firms is the frequency of contact with their counterparty. Nearly all the KIC firms indicated that they communicated with their primary counterparty on a daily basis; for a handful of the non-KIC firms communication was as infrequent as once a year.

⁸Recall that organized private networks did not appear to play much of a role in encouraging firms to begin business in North Korea.

⁹Two other firms reported extending loans to their South Korean counterparties. These results parallel those obtained in the China survey where less than 5% of the firms reported extending credit to their partners, with most of these cases (60%) involving Chinese SOEs extending loans to their North Korean SOE counterparties at a rate enormously disproportionate to this dyad's occurrence in the sample (5%).