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Role of International Financial Institutions in North Korea's Economic Development

Role of International Financial Institutions in North Korea's Economic Development

LEE Han-Hee

Dec. 1, 2009

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Originally released on November 24, 2009

ABSTRACT

The North Korean economy has had zero or minus growth since 1990. Currently, its official economy is almost paralyzed, while a second (unofficial) economy is expanding rapidly. A key determinant is a lack of initial capital to mobilize economic growth engines. The North Korean regime is now going all-out to prevent the spread of the second economy and to reinforce the nation's socialist planned economy. This effort, however, is bearing negligible fruit. The economic growth rate of a country, in general, is determined by domestic savings rate and investment rate. Today, North Korea has difficulty even in basic production and, therefore, cannot increase factor inputs. To cope, North Korea is looking for external assistance.

North Korea is now mired in "coordination failure" - a common cause of under development - due to its conflicts with the global community over its nuclear development program. In short, mutual distrust between North Korea and the international community has trapped them in a prisoner's dilemma, wherein neither side can increase factor inputs. Coordination is needed for a breakthrough, but it is difficult for a single nation to take the initiative as a coordinator. Against this backdrop, international financial institutions could be the best alternative (BATNA) to thaw the situation. International financial institutions (IMF and World Bank etc.) founded by the US and its 45 allied countries in 1944 are aimed at promoting international economic cooperation, on the basis of the lessons gained from the Great Depression and the two World Wars. Although international financial institutions cannot extend assistance to North Korea under the current environment, where the potential of a nuclear crisis c ontinues, they have already mapped out an "internal assistance plan" (short-term assistance to food and energy industries and mid- and long-term assistance to the construction of social infrastructure) for when the nuclear crisis is resolved. Such assistance could be extended even before the North's entry as a member country in international financial bodies. However, it is not clear whether the assistance could actually develop the NK economy, thereby meeting their founding objective of facilitating private investment to promote economic development and enhance the quality of life in underdeveloped countries that lack domestic savings for new investments. To clarify this, this paper conducted a quantitative analysis on the influence that assistance from international financial institutions has had on the ability of former east European bloc countries to attract foreign direct investment (FDI). Before its collapse, the bloc adhered to socialism, just as North Korea does today. Since 1992, the bloc nations have received about US$8 billion worth of assistance annually.

Through its analysis, this paper derived implications applicable to North Korea. The analysis covered 27 countries in the east European bloc who changed governments and later received assistance from three international financial institutions (IMF, World Bank and the European Bank for Reconstruction and Development) in 1990-2006.

The analysis found that the assistance from the international financial institutions did not directly affect inbound FDI of east European nations during the year they received aid or even one or two years later. However, there was a linear relationship between FDI inflow and the weight of the private sector in GDP as well as the weight of trade in GDP. This can be interpreted to mean investment by foreign private capital depends on the degree of economic openness and private sector development, regardless of the amount of assistance from international financial institutions.

Per-capita GDP growth was seen to have a negative impact on the influx of FDI. This may mean that a higher per-capita GDP growth (income growth rate) had a negative effect (hike in personnel expenses) on investors. Another analysis was also conducted by dividing the countries into two groups - CSB (Central and Southeastern Europe and the Baltics) which overcame the recession caused by regime changes and achieved economic growth rapidly and CIS (Commonwealth of Independent States) which has experienced a protracted slump. The analysis showed that regardless of regional classification and the assistance by international financial institutions, the influx of FDI depended on the weight of the private sector in GDP and the weight of exports and imports in GDP.

Last, the analysis of the correlation between the assistance by international financial institutions to specific industries and the inbound FDI showed that the assistance to manufacturing and trade, infrastructure and traffic, real estate and travel exerted a favorable influence on the influx of FDI. In contrast, the assistance to natural resources and energy industries had modest effect on FDI inflow. The case analysis of CIS and CSB countries empirically verified the results of the statistical analysis.

In conclusion, this paper reevaluated the assistance program of the World Bank and the areas of assistance demanded by North Korea in 2007 by using the above-mentioned empirical analysis. It aimed at presenting a slate of ideal roles for international financial institutions to play in the economic development of North Korea, as well as, finding which areas should be given priority in assistance.

With respect to ideal roles, international financial institutions could extend initial capital as a catalyst to promote the North Korean economic development. Second, they should focus on improving North Korea's investment environment, aimed at clearing the way for foreign private capital to invest in North Korea. Third, given the international political situation facing the Korean peninsula, they could play the role of a "second coordinator" to free the North Korean economy from the prisoner's dilemma. To this end, a "trial project" approach should be adopted by limiting the assistance to specified areas (special economic zone etc.).

As for assistance priorities, support should be given to manufacturing and trade areas that could attract foreign capital more easily than others. Among the requests by North Korea, increasing the scale and ensuring substantial operation of the Gaeseong Industrial Complex and the development of a special economic zone in Haeju region (Gangryeong-gun is under review) could be made in this regard. Second, investment cooperation between international financial institutions, government and the private sector could be aimed at invigorating manufacturing-related trade through the construction of social infrastructure in North Korea, including inter-Korean cooperative strongholds such as special economic zones and a logistics network connecting them. Third, it would be effective to provide assistance to financial and insurance areas that specialize in promoting smooth investment in manufacturing, trading, infrastructure, and transportation. Fourth, although assistance to upgrade farm villages is not expected to attract much private investment, consideration should be made with North Korea's food shortages in mind. Lastly, educational and training programs for government officials need to be given support to enable North Korea to achieve an economic growth on a long-term basis.

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