The Peninsula

Kim Jong Un: Crossing the Rubicon and Slipping on the Stones for Economic Reform

By William Brown

Kim Jong-un has been unusually silent about the election of Donald Trump.  Does this represent fear of how a tough new U.S. administration might react to his usual posturing or indecision as to how to proceed with his dual nuclear weapons and economic development programs?  Perhaps Kim feels his plans are progressing adequately without the need for new provocations.  After all, despite the protestations of the Obama administration which said he can’t have an improved economy and nuclear weapons, Kim seems to be having success in both.

Not all is easy for Kim, however, and he must soon make important and probably irrevocable decisions with respect to how far he will allow the market economy to expand.  China’s Deng Xiao Ping said he simply “crossed the river” of reform by feeling for underwater stones.   But one has the impression that Kim’s river is full of more slippery stones, and a swifter current. His economic progress to date is the result of a risky expansion of market forces, no doubt unnerving to anyone in Pyongyang who understands the economic forces that tore down other communist states, and are likely driving big disparities in incomes of state and private sector workers.  As Kim and his advisors draw up his always important New Year’s message, which will come prior to Trump’s inauguration and can thus set the stage for future relations, it makes sense for us to dig a little deeper into the challenges that confront the still young leader.  In an ideal world we could construct new policies that can pull or shove Kim across the river of reform.

Recent North Korea Daily reporting makes me realize that we may be missing the speed at which the transformative market-building process is underway in North Korea, permanently changing the nature of the country. Whether this bodes well for Kim Jong-un is yet to be determined but certainly major changes are in the works that impact the way he governs the country.  Whereas, we have long known that the command or centrally planned system in North Korea was broken, I have thought of the economy as caught in a trap between market and plan, unable to decisively shift in either direction and thus beset with the weak productivity and corruption inherent in any dual economic system. The two prices for each product and service that such dualism implies are a big problem in economics, and a big opportunity in business.  And from either perspective, the dual structure is not sustainable without strong police powers.  The inevitability that even a police state eventually succumbs to profit and corruption may finally be forcing a move toward the market, or one-price economy.  This is likely letting loose a big growth in productivity—better use of labor and capital—even without new capital resources. Ironically, the nuclear program, sanctions, and the stoppage of foreign aid, are contributing to this momentum.

The main marker of North Korea’s transition economy trap has been the astonishingly large and persistent difference in prices for goods and services, and wages, between the state economy and the private, largely unregulated, economy.  A textile worker in the state system is paid about 3,000 won a month, and receives essential food and housing at low, rationed prices, while the same worker in a Chinese-invested and run factory, selling shirts for export, could earn 100,000 won a month, but with no cost-cutting rations—she would have to procure necessities at prices in the markets at up to 100 times higher than the fixed ration prices. Which worker, state or private, was better off depended on the reliability and quality of the rations, and supply and demand conditions in the marketplaces.  As we have watched over the years, the tide has turned slowly but unmistakably in favor of the market participants and I’d say this tide is now in full flow. It seems that almost all state workers have some sideline or private sector deals, giving them cash they can use in the markets. An insight from last week’s Daily North Korea; state sector employees are now renting rooms in their state supplied apartments, at market rates, to young people coming in from the countryside. The migrants, apparently better treated than such workers in China’s cities, work for low but at least reasonable market wages and are completely independent of the socialist benefits system.

And in this extraordinary unequal dual system, Pyongyang’s Chosen Bank has been able to get away with charging diplomats, UN programs, and foreign aid providers, $100 for a stack of won notes worth about 15,000 won, whereas street market vendors and department stores would provide the same bundle for only $2 to anyone not worried about their visa. Enterprising North Koreans can make a fortune bridging these gaps, putting aside some arbitrage for the policeman or the local Worker’s Party secretary.  Tourism companies, once they learn to negotiate the best prices with private and state suppliers, begin to make money.[i]

This dualism has been festering for a long time.  Ten years ago, in a paper I drafted for Stanford’s Shorenstein Center, and published as a chapter in its “North Korea 2005 Outlook,” I developed a list of indicators that I figured would help determine when and if Pyongyang was undertaking Chinese style reforms, as described by Deng Xiao Ping in his “crossing the river by feeling for the stones” speech.  The scorecard at the time leaned slightly toward the left, meaning “not yet”.  While many indicators were becoming more positive to reform, especially the appearance of markets and the decline in rations, heavily weighted indicators were still solidly socialist. In talking with Chinese Korea specialists at the China Reform Forum in Beijing, a foreign affairs government think-tank, and elsewhere, I had decided the most important indicator would be the breakup of the communal farming system.  China’s central government allowed, or was too weak to stop, the breakup of collective farms in 1978 and thus created the “household responsibility system” that quickly led to private farming and a virtuous spiral in productivity, use of markets, mobile labor, money, further de-collectivization, exports, imports of capital, investment and still more productivity growth.  By 1983 a billion peasants had been liberated from their oppressive party masters and were farming their “leased on-a-track-to-own” land.  But in North Korea, at least by 2005, despite the emergence of markets, nothing of the sort had happened.  The Chinese economists were perplexed as to why, thinking it was Korean village culture.  I thought it was too much foreign food aid that was allowing the regime to fill rations by just enough to stave off the pressure to allow private farming.  And free foreign grain kept food prices too low for private farmers to compete.  China had never allowed foreign aid of that sort and Chinese farmers had much more to gain from market pricing.

There was another key obstacle against which Pyongyang had made little progress.  Mao’s China had long protected its money and banking system, and its international credit, from the worst socialist practices so incipient Chinese entrepreneurs had money to work with and foreign companies willingly invested once Western sanctions came off and trade began.  But in North Korea, the monetary system had been all but destroyed by the Kim Il-sung and Kim Jong-il regimes.  And internationally, the country was, and remains, bankrupt, with Western, South Korean, and Japanese hard currency “policy” or “friendship” loans never having been repaid.  With the double barrier of bad money and no international credit, it was hard to see how North Korea could progress through the minefield of Chinese capitalist reforms.

So ten years later, what are these indicators saying?  The private farming indicator is still ambiguous for reform since the collectives are still in place.  But we need better information on exactly what is occurring on these farms.  Experiments modelled on something like the Household Responsibility System were discussed in the North Korean media about three years ago.  These were to sharply lower the size of work teams to essentially a family unit level. And extra-quota output was to be allowed to be sold at market prices.  Is this happening?  I’m not sure, but lots of grain seems to be available at market prices and I don’t know where else it would be coming from.  Still, there are plenty of reports of the North Korean military confiscating grain from farmers at the height of the harvest season. In China, the momentous change from 1978-1983 was not well observed by outsiders so we need to be careful about what we assume to know.

This important indicator aside, my other indicators have moved sharply in the market direction.  A few examples:

• North Korea Daily articles remark that individuals are now able to rent housing at market rates in North Korean cities, moving their registrations from farms or villages.  The rent money circulates, giving incentives for state units or the military to build housing at market prices and rent out units for profit.  Children of farmers are doing this to gain access to jobs that obviously pay market wages, and are thus removing themselves from the socialist system entirely.  What is remarkable is this seems to be ahead of China, where the hu-kou registration system makes such migrants little better than illegal immigrants. In North Korea this seems legal and even welcomed given the rise in work-force productivity.

• Interindustry goods are now apparently being bought and sold on market terms, with even state owned firms paying no attention to plan quotas and prices.  This encourages a great rise in productivity since if an input is in short supply, rather than just waiting for the plan to deliver, a firm will bid for the input with a higher price offering, and a supplier will be incentivized to make more of it.

• Prices of ordinary goods, taking the price and divided by market exchange rates, appear remarkably close to world market prices, or at least Chinese market prices.  Mixed quality anthracite coal for home heating and cooking, for instance, was priced at about 310,000 won a ton in November in northern North Korea, or about $38 using the prevalent exchange rate.  In central Pennsylvania, the price of a ton of similar coal was $42.25 according to the U.S. Department of Energy. The market price of high calorie anthracite coal exported to China in September was $46 a ton but is said to have risen sharply to above $60 in October and perhaps even higher in November as China is trying to limit coal production, shooting up prices as the winter season sets in.[ii]

• Electricity, which in the state system is essentially free if you can get it, is now being produced by individuals using solar panels imported by entrepreneurs from China, and sold to users who will pay top dollar to charge their cell phones.  Similarly, generators needed to pump water to high rise apartments, and the fuel to feed them, are in high demand. Even Pyongyang residents are thus cutting their links to the moribund state economy.

• NK Daily notes that families of defectors to the South are being treated a tiny bit more kindly by the regime, given their secret remittances of hard currency to relatives in North Korea, and that the abhorrent guilt-by-association penal system, in which families of defectors are sent to camps, is slowly being weakened. More substantiation of these claims is needed, given the bias inherent in defector reporting, but it makes sense that as a market economy spreads, the opportunity costs of such camps becomes very high since it takes productive people out of the workforce. The same can be said for the huge, unproductive, military.

• North Korean exports of textiles and apparel, items of likely comparative advantage but not exported from the planned economy due to their domestic needs, have soared in recent years, despite sanctions.  Anthracite coal exports, also likely driven by local market conditions, also are doing well and again despite sanctions. Small mines appear to operate outside the plan and can make much higher profits selling to China, or to households, than to the state owned electric power station which remains tied to the broken planned economy.

• One item that I listed that has not turned positive seems small but is important.  North Koreans still don’t seem to be allowed to use the “reform” term that, in China, indicated major system changes were underway.  If Kim can find a way to begin to use this kind of terminology it can have a huge transformative impact on state industries that currently don’t know what to do to compete with the markets.

These indicators which in 2005 in the aggregate leaned slightly left now lean significantly to the right, suggesting positive market oriented change, but what about the tough money and credit obstacles?  A clever but rather chaotic solution seems to be addressing the money problem, if not yet solving it entirely. I could not have guessed the extent to which the regime would allow the economy to become dollarized—that is to allow the use of the U.S. dollar to pervade and even underpin the won monetary system.  Kim Jong-il tried to stop the phenomena in December 2009, but since that failure, for which the regime even apologized for ruining the value of won and stealing the public’s financial savings, the regime seems to have given up on foreign exchange controls.  Kim Jong-un either learned a tough lesson or is oblivious to what is happening.  From a monetary policy perspective, this is about the toughest measure a government can take to rebuild monetary trust since, deliberately or not, it gives up control of the money supply, accepting however much foreign currency the economy can earn by exporting and bringing in as investment.  This is like a U.S. state, or a government like Hong Kong that uses a currency board, and thus cannot create its own credit or money.  Pyongyang has not quite gone this far, and it still prints its own money, but it has been careful not to print too much to create inflation and a further flight to the dollar (See 7 September Blog).  Somehow it has been able to hold the line on state sector wage increases, not matching the much higher private sector wages, and instead is allowing state employees greater flexibility in renting state assets, such as factory space, to increase their private incomes.

As this continues, Pyongyang may gradually begin to liquidate state assets, selling or renting capital and real estate assets to private users so as to earn back the money needed to compete with market sector wages and prices. As has occurred in China, given the amount of state assets, this could go on for a long time, raising productivity while keeping the government financially solvent.  But it is a dangerous political activity for a socialist country to privatize and Kim is already quite late in setting the rules.  The killing of his uncle, probably for making too much private money out of state assets, well illustrates the problem. With tremendous arbitrage opportunities, one can imagine lots of private thinking in Pyongyang as the New Year arrives, and dreams of new family fortunes.  And as a new administration takes charge in Washington, might we see a “Trump Hotel” for Pyongyang?  Odder things have happened.

William Brown is an Adjunct Professor at the Georgetown University School of Foreign Service and a Non-Resident Fellow at the Korea Economic Institute of America. The views expressed here are the author’s alone.

Photo from Clay Gilliland’s photostream on flickr Creative Commons.