ECONOMIC COOPERATION ON THE KOREAN PENINSULA

Bradley O. Babson

Consultant

A Working Paper prepared for the Task Force on U.S. Korea Policy sponsored by the Center for International Policy and Center for East Asian Studies, University of Chicago,
Brookings Institution, Washington, January 9, 2003

Introduction

There has always been an undercurrent of ambivalence in U.S. attitudes towards economic cooperation with the Democratic Peoples' Republic of Korea (DPRK). On the one hand, an economically weak DPRK is inherently less capable of waging war and developing weapons of mass destruction than an economically strong DPRK. From this perspective, the economic distress of the 1990's clearly has altered the security balance in favor of U.S. and Republic of Korea (ROK) interests. On the other hand, an economic collapse in DPRK could lead to potentially highly destabilizing developments, including large-scale population movements across borders and the risk of the leadership initiating armed conflict as an act of desperation. Similarly, continuing economic distress could force DPRK to revert to dependence on China and Russia, perpetuating its isolation and inhibiting the creation of a new security architecture for Northeast Asia that better suits the interests of all Big Powers concerned than continuation of the status quo.

In recent years, U.S. statements and actions relating to economic cooperation with DPRK have been decidedly lukewarm. Examples are: a deliberately slow-going implementation of the KEDO light-water reactor project; honoring commitments for heavy fuel oil shipments under the Agreed Framework with only grudging acquiescence by the U.S. Congress; promotion of food-for work in provision of humanitarian assistance; half-hearted, delayed and partial lifting of U.S. economic sanctions in relation to commitments made in missile talks ; encouragement of economic reforms and access to knowledge of market economic systems, accompanied by chilly responses to DPRK's efforts to reach out to international financial institutions; and rhetorical support for inter-Korean economic initiatives, accompanied by efforts to undermine some of these initiatives, especially those involving actions that would lead to breaching the DMZ or direct provision of energy supplies. It is also noteworthy that neither in William Perry's policy prescription for future relations with DPRK, nor in the missile negotiations conducted by the Clinton administration, were there economic benefits of any meaningful scale to be provided by the U.S. to DPRK. These statements and actions send mixed messages, reflecting the underlying ambivalence of American attitudes towards economic cooperation with DPRK. This is also reflected in the present posture of the Bush Administration, which essentially is calling for satisfaction on unilateral action by DPRK regarding its nuclear program before considering cooperation on either the security or economic agenda.

The argument that I would like to make in this paper is that economic conditions in DPRK and the nature of DPRK's relations with other countries have changed so fundamentally that ambiguity on economic issues is not a viable option for future U.S. policy. Also, economic relations in Northeast Asia are undergoing fundamental changes and the U.S. needs to position its future policy in the context of the wider regional perspectives. The focus of debate needs to shift to defining strategic goals for U.S. policy on economic engagement with DPRK and Northeast Asia, and to defining and building consensus on modalities for advancing these strategic goals.
DPRK's Dilemma

A major dilemma for the DPRK leadership is how to reconcile the political philosophy of Juche self-reliance with the reality that the DPRK economy cannot become viable without expanded trade and investment relations with other countries on the basis of market economy mechanisms and domestic economic reforms to increase production and profitability of enterprises and farms.

The continuing tendency to put political philosophy ahead of economic realism is reflected in the following statement from the Korea Central News Agency (KCNA) on November 4, 2002:

"Self-sufficiency in the economy elucidated by the Juche idea is a guiding
principle of the party and state activities for applying an independent stand and
creative stand in the revolution and construction. Adhering to the principle of
self-sufficiency in the economy means building an economy which is free from
dependence on others and which stands on its own feet, an economy which
meets the material demand of one's own people and country by itself.

The Juche idea clarifies that economic self-sufficiency is essential for definitely
guaranteeing the political sovereignty and independence of the country and
providing an independent and creative material life to the popular masses. Only
on the basis of economic self-sufficiency, can any nation defend the political
sovereignty, build a prosperous independent and sovereign state and provide
an independent and creative material life to the popular masses.

In order to achieve economic self-sufficiency, it is necessary to adhere to the
principle of self-reliance and build an independent national economy. One
cannot build an independent national economy and solve one's own problems
by depending on others. If an independent national economy is to be built, the
economy must be developed in a diversified and integral way and establish
one's own reliable and independent sources of raw materials and fuel. It makes
it possible to fully meet the material requirements of one's own country and
people and develop the economy in a safe and forward-looking manner.

The Juche idea gives a scientific exposition of the principle of economic self-
sufficiency and ways of achieving it, thus providing an ideological and
theoretical weapon to build a powerful independent and sovereign state and
make an independent development of the nation by strengthening the country's
economic independence and consolidating the material and technical
foundations of socialism."

The reality is that DPRK economy has always been dependent on subsidies from foreign trading partners. Historically, China and the Soviet Union provided these subsidies through "friendship prices" and counter-trade, and more recently the U.S. and other countries have provided these subsidies through KEDO oil shipments and humanitarian assistance, while China has continued to provide significant levels of bilateral aid and subsidized trade. Facing up to economic realities in the future will require that the DPRK leadership acknowledge the historic dependence on generosity of other countries and shift from behaviors that seek to extract subsidies from other countries to maintain viability of a failed system, to behaviors that foster foreign aid and investment on terms acceptable to the international community based on improved relations and commonly accepted financial practices. To accomplish this shift, it is also necessary that the DPRK leadership accept the political implications of the fact that economic survival depends on deepening not lessening economic interdependence with other counties. In the end, the Juche philosophy cannot achieve its basic goals in the economic sphere, and is destined for the same creative re-interpretation as the ideologies of the Communist Parties in China and Vietnam have undergone in recent years.

It will not be easy for DPRK leadership to take the necessary steps towards economic viability. DPRK has not in the past been willing to use economic crisis to advance economic reform, as was the case in China and Vietnam, and throughout the 1990's resisted undertaking bold reform measures. Even so, the DPRK economy been in the throes of dynamic change for over a decade and the realities of these changes cannot be ignored. In 1998, DPRK made Constitutional revisions that did set a legal basis for economic system change and also implemented a government restructuring, and in recent years there have been piecemeal efforts to make improvements in various aspects of the economy, including the foreign investment regulations.

Despite Juche rhetoric, the DPRK leadership is now in a position where it has been forced to recognize that it alone cannot achieve a viable economic future through piecemeal measures, and in fact must expand external economic relations as a central component of its strategy for regime survival. As a result, the present strategy being pursued seems to be a two-track approach. Special economic zones will be permitted to function as enclave attractors for foreign investment and foreign trade and operate under international market principles, while domestic industry and agricultural production systems will be transformed under an economic reform policy that nevertheless seeks to maintain a military-first and socialist orientation. The economic reform initiatives that have been announced starting in July 2002 represent a deliberate decision of the leadership to take irreversible steps to implement this strategy, despite many uncertainties and ideological inconsistencies.
Changes in the DPRK Economy

To set the present reform initiatives in context, it is useful to summarize the basic story of economic changes in DPRK in the1990's and the present state of the economy.

DPRK entered the 1990's with a capital stock that had been deteriorating for many years and subsidized trade relations with the Soviet block and China. The combination of the trade shock that followed the collapse of the Soviet Union, hardening of China's terms of economic trade with DPRK following diplomatic recognition of ROK, and natural disasters that affected agricultural output, triggered the dramatic economic contraction between 1994 and 1998. During this time the national budget dropped from 41.6 billion won to 19.8 billion won, and estimates of the Gross National Income (GNI) fell from $21.3 billion to $12.6 billion. Since 1998, both the budget and estimates of GNI have stabilized and recovered slightly, suggesting that this was the nadir moment for the DPRK economy. This trend was confirmed by the 2002 budget of 22.2 billion won, which is 2% higher than the 2001 budget.

This assessment is mirrored in energy statistics. DPRK's total energy supply dropped from nearly 24 million tons of oil equivalent in 1990 to a low of about 14 million tons in 1998, and then recovered to about 15.7 million tons in 2000. Coal production, which accounts for about 70% of North Korea's energy supply, also fell sharply from about 16.6 million tons of oil equivalent in 1990 to 9.3 million tons in 1998, and rose to 11.2 million tons in 2000. Crude oil imports, however, are at an extremely low level, having dropped from 18.5 million barrels in 1990 to a low of 2.3 million barrels in 1999 and rising slightly to 2.9 million barrels in 2000. (In contrast, crude oil imports in ROK were 894 million barrels in 2000). Lack of fuel for transport as well as power is a critical constraint to economic recovery.
The agriculture story is slightly different. United Nations estimates of cereal production show a precipitous drop from about 4 million tons in 1995 to about 2.8 million tons in 1996 and 1997, followed by a modest recovery to about 3.5 million tons in 1998, which remained at about this level in 1999, dropped to 2.6 million in 2000, and rose again in 2001 to 3.5 million. The fluctuations reveal the vulnerability of North Korean agriculture to weather factors that affect yields. But the underlying story is that even in a good year such as 2001, cereal production remains far below the yields of the early 1990's and a food deficit of between one and two million tons per year is a structural reality for DPRK.

The trade shock of the early 1990's was characterized by a sharp drop in imports from a level of about $2.8 billion in 1990 to a low of $.9 billion in 1998. This began to stabilize in 1999 at $1 billion and recovered to $1.4 billion in 2000, with estimates for 2001 based on the first six months suggesting acceleration to over $2 billion, reflecting the maturation of the humanitarian assistance programs, the Mt. Kumgang Tourism Project, and KEDO's Light Water Reactor construction project. Exports, however, have been in continuing decline throughout the 1990s from a level of about $2 billion in 1990 to about $0.6 billion in 1998, with only small signs of recovery since then. An important development has been the increasing role of inter-Korean processing-on-commission (POC) trade, which has grown steadily from about $7 million in 1993 after the signing of the Basic Agreement in 1992, to about $125 million in 2001. POC trade now accounts for over 30% of inter-Korean trade. While these trade trends help explain the easing of economic pressure on DPRK since 1998, they do not suggest that DPRK has found a way to significantly expand export earnings that will be needed to finance food security and economic growth.

Foreign investment in DPRK remains extremely low, with virtually no official development assistance and very little realized capital from foreign direct investment. For example, the Rajin-Songbon Enterprise Zone had attracted contracts valued at $650 million, but only realized $120 million by 2000. Despite the "sunshine" policy, ROK investments in DPRK have been mainly limited to the expanding POC trade.

Perhaps the most dynamic and interesting development in the DPRK economy in recent years has been growth of the informal markets. Following the sharp economic contraction of the early 1990's, these markets have grown both in number and composition of products for sale. Resources are now flowing into the markets from a number of sources: agricultural surpluses produced by cooperatives and households that exceed State purchases, leakages from overseas food aid, commodities from cross-border trade with China, asset stripping from State enterprises, diversions from the Public Distribution System (PDS) of production from State enterprises, production from small family enterprises, and services now being offered in the markets. With the breakdown of the PDS as a mechanism to feed the urban population in the late 1990's, these markets have been stimulated by demand for basic consumption items as a household response to deprivation. However, prices in the markets are generally set in reference to border prices in China, although there are price differences in different parts of the country. These prices have far exceeded official prices until the recently announced price reforms.

There are also many informal reports of the "dollarization" of DPRK, as the dollar, Yuan and Yen are used as the medium of exchange for domestic transactions. This is not surprising given the differences in price levels of the official and unofficial economies and the availability and denomination of won currency. Privately held foreign currency amounts to about $1 billion, more that twice the value of domestic currency in circulation.

In addition to the expanding role of informal markets, there are reports from NGOs that market mechanisms have been growing in other areas, such as transport of drugs, where contracts to semi-private drivers are replacing use of government vehicles. Also, it has recently been reported that small family businesses of 3-5 workers are expanding with official recognition, producing a variety of hand-made products for sale in the local markets. These developments suggest a "bottom-up" process has been underway of economic system change that is a response to practical necessity, even if not guided by policy.
An overall assessment is that the DPRK economy is now in a fragile low growth mode, dependent on disbursements of foreign funded projects, humanitarian assistance programs, and Chinese aid and subsidies. Internal economic dynamics are also increasingly influenced by unregulated growth of the informal market economy. In the absence of the ability to mobilize a large infusion of foreign resources needed for investment, this is not a stable situation and is the reason why more dramatic system reforms are unavoidable.

Assessment of Economic Reform Initiatives

Announcement of Reforms. In July 2002, reports began emerging of significant reforms in prices and wage rates and other aspects of DPRK's economic management system. Essentially, these included increased in prices of rice and other basic commodities purchased through the PDS to levels approaching those prevailing in the informal markets, and also increases in wage rates that were differentiated by occupational categories. Wage increases are reported to be 10-20 times the previous rates of 100-200 won per month. These wage differences for different occupations reflect preferences of the government that were formerly embedded in the rationing system, and not the relative values that would be placed on labor if there were a true market; thus they should be interpreted cautiously. The government's intention is to retain the PDS to ensure that all citizens receive a minimum ration of food staples, the scale of those rations still being subject to food availability. Any surplus above this would be available according to ability to pay. In addition, households will be charged for rent and transport at much higher levels than previously. The policy is to maintain free provision of social services such as education, health and child care. State enterprises are now expected to be self-sustaining without state subsidies, and will be free to set their own production plans and engage in commercial transactions. The combination of imposing a hard budget constraint and decentralizing decision-making represent significant changes in enterprise policy.

On August 14, a devaluation of the North Korean won was reported from 2.15 to 150 per dollar. The black market rate was at the time about 230. The new won is non-convertible and the convertible won has been removed from the market. The tight control over the won means that these actions alone will not increase export competitiveness or raise the purchasing power of foreign currencies. These actions are similar to those taken by China in 1994 when it abolished the Foreign Exchange Certificate.

In a meeting with UN Undersecretary for Humanitarian Affairs, Kenzo Oshima. on August 1, the President of the Supreme Peoples' Assembly, Kim Yong Nam, stated: "We are reactivating the whole field of the national economy…We are directing our whole efforts to restructure our economic base to be in line with the information technology revolution… and as we have done since 1945 we are undertaking reforms in line with the prevailing situation, in the best interests of the people…we are reforming the economic system on the principle of profitability."

It is worth noting that there is no hesitation to use the "reform" word. This is a change from past avoidance of this term. Also, it is clear that the intention is to make system change, not to adopt measures designed to protect the old (failed) system. The general objective is to seek economic improvements through increased use of incentives for profitability and adoption of new technologies, while maintaining a socialist system. DPRK has not yet embraced price liberalization and market regulation as part of its reform program, leaving the informal markets outside the official economy. There is no information about the impact of the reforms on the military and its special economic privileges.

On September 12, the Supreme People's Assembly passed legislation establishing a Sinuiju special administrative zone along the border with China. Under the new law, the region will have very substantial autonomy and will be run under liberal economic and political policies to attract foreign investment and stimulate trade with China. The idea is to set up a locus of economic and social dynamism. Potentially this innovation could both result in increased flows of investment and trade and introduction of new technologies and management approaches that could have spill-over effects on the rest of the North Korean economy. Indeed, together with the proposed free enterprise zone in Kaesong and talk about establishing one in Wonsan on the east coast, DPRK appears to be proceeding with a strategy to develop enterprise zones that operate on free market principles in different parts of the country to attract foreign investment and expand trade.

Assessment of Reforms. Essentially, what DPRK has done is (a) monetized economic transactions, moving away from a system based on physical planning and rationing to one where money will play a much larger role at prices closer to informal market prices, even if prices are still controlled; (b) changed the incentives environment for labor, enterprises and agricultural production to encourage increased productivity and profitability; and (c) adopted strategies to increase foreign investment and trade and improve the potential for obtaining foreign aid. These are all worthwhile objectives, even if they are limited.

The shift to monetary mechanisms and rewards based on performance represent major systemic changes for the DPRK economic management system. While there are many gaps and uncertainties about the full scope of changes underway and their implications, no one is questioning the sincerity of the government's initiative to embark on top down-led economic system changes. However, the reforms are not sufficient to assure a turnaround in DPRK's economic crisis and even add new risks, particularly the risk of inflation. In fact, there are indications that the price of rice has already nearly doubled in the informal markets and the unofficial dollar exchange rate has dropped from 230 to over 500 . To achieve sustainable economic growth, DPRK will need more policy reform towards a market economy, attention to developing institutions needed for macroeconomic management and to implement change, and mobilization of resources to finance investments in physical and human capacity that are needed to support the policy and institutional changes.

It noteworthy that the reforms were top down, planned and managed, and not ad hoc response to growing pressures. This is different from the way we have seen changes in recent years, especially the government's tendency to adopt partial measures, and the growth of the informal markets as an unplanned and unmanaged response to reality facing households.

It is also not clear that North Korean officials have enough knowledge of economics to design and implement the reforms in a way that will achieve the desired results. They have been sending study teams abroad and have been doing homework on their own, but there is no evidence that they are receiving advice from any knowledgeable outside source on the reform process. Thus, even if the political will exists, there is little known capacity to support the planning and management of economic system change. From this perspective, the recent reform initiatives could be seen as a courageous decision for the DPRK leadership or one of desperation.

There is also a tendency as noted earlier to put political thinking ahead of economic pragmatism. A recent example is the decision to suspend use of U.S. dollars as a medium of exchange for transactions within DPRK. Foreign Embassies, INGOs and UN agencies are now being requested to use Euro currency rather than dollars for their official foreign exchange transactions, and the government is hoping to realize a windfall gain by requiring that households trade in their hoarded dollars for won. It is highly unlikely, however, that administrative decisions of this type will result in voluntary compliance or significant lowering of use of dollars as a store of value for households and in the informal markets, and efforts to enforce the ban can only make life more difficult domestically. Such measures will have no impact on the U.S. itself, whatever the intention or expectation of the leadership in adopting this policy.

DPRK's External Economic Prospects

In recent years, China, Japan and ROK have emerged as DPRK's major trading partners, and it is likely that these three countries will dominate DPRK's investment and trade relations for the foreseeable future. In addition, expanding trade with Europe and Russia have potential if DPRK is successful in creating an economy that can produce goods that are attractive for these markets. As a practical matter, sustained economic growth for DPRK will require adoption of an export-led strategy similar to that followed by Japan and ROK in recent decades. From this perspective, the strategy of creating a number of enterprise zones to attract investment and produce goods for these several external markets is economically reasonable. However, given the disappointing experience of the Rajin-Songbon Enterprise Zone, it is not likely that this strategy will be successfully implemented without a lot of attention to ensuring that the ways these zones are planned and implemented take due account of the needs of investors and markets. The rocky and politically embarrassing start-up of the new Sinuiju special administrative zone does not convey any degree of confidence that the DPRK leadership understands the fundamentals of how such zones can be successful.

Economic Integration with ROK. The economic relationship between the two Koreas will become increasingly complex as the two countries deepen their reconciliation efforts. While neither country currently espouses early political unification, both see enhanced economic cooperation as desirable to lesson tensions and to reduce the enormous gap that has grown between the two economies, both in scale and in structures. Any reconciliation process must have an economic dimension, and the agenda and mechanisms for managing inter-Korean economic cooperation have grown very significantly since the June 2000 Summit. Both at the government and enterprise levels, inter-Korean economic and commercial contacts have now reached a point where it is inconceivable that there be a regression to the pre-2000 era, regardless of the bumpiness of the road towards political reconciliation and DPRK's relations with Big Powers. An important dimension of future U.S. policy in its relations with both Koreas in the coming years will be how to relate to the expanding inter-Korean economic relationship.

China. China's entry into the World Trade Organization is transforming its economic relations with its neighbors as well as with the international community as a whole. The challenge for DPRK is how to be competitive in China's markets. Teaming up with foreign firms and combining transferred technology with North Korean low cost labor could provide one effective strategy for penetration that would serve the interests of both parties. (A similar strategy is potentially viable for future access to European and American markets). An issue for future U.S. policy is whether to adopt a supportive posture towards investing in DPRK for export to China and other markets. This will affect not only U.S. companies that might consider such investments an attractive part of their business strategies for penetrating the China market, but also raises the issue of use of American-licensed technologies by South Korea firms or those from other countries that might be considering investing in the DPRK enterprise zones. Under present regulations, there will be considerable legal issues to be resolved if DPRK pursues this type of investment and trade strategy.

Japan. Japan already consumes seafood and light manufactured goods produced in DPRK and bilateral trade is presently about the same level as DPRK's trade with China. In the future, if the two countries normalize relations, expanded access to Japanese markets and finance would likely lead to a large increase in investment and trade that will significantly benefit DPRK. Similarly, the economic assistance package that Japan is promising as part of the normalization negotiations, will make available to DPRK resources for large scale infrastructure investment that is needed for DPRK to attract foreign investment and achieve sustainable economic growth. This is likely to include resolution of outstanding bilateral debt and export credits to support private investment flows, as well as official development assistance (ODA) to be provided both through bilateral and multilateral channels. Japan is thus positioned to become a very important economic relationship for DPRK in the future and will exert considerable influence on economic engagement policies. The Japanese economic relationship with DPRK can also be expected to be a complicating factor in future evolution of inter-Korean economic relations, as DPRK hedges its growing inter-dependence with ROK by expanding bilateral links with Japan.

At present, Japan is handling its economic relations with DPRK in three ways. It is linking resumption of humanitarian food aid to resolution of political issues that are important to the Japanese public, notably the resolution of concerns relating to abducted persons and their families. It is coordinating closely with the U.S. and ROK in the management and financing of the KEDO oil shipments and light-water nuclear reactor project. And it is calibrating its normalization of relations talks to progress on the issues relating to weapons of mass destruction and will not proceed with an economic package for DRPK until these concerns have been addressed. In the short run, Japan's posture is to add economic pressure on the DPRK leadership to act on the major issues of concern to Japan and the U.S., while holding out the prospect of significant tangible economic assistance if these concerns are addressed. Maintaining this close coordination of U.S. and Japanese policy will continue to be a high priority for the U.S. In the medium and longer term, however, Japan's interests in expanding ties with DPRK may not coincide so closely with the interests of the U.S. and this is likely to emerge in the way in which economic relations are handled. If DPRK delivers to Japan what it is seeking on the handling of abductee families and other purely bilateral issues while succeeding in stonewalling on dialogue with the U.S. on the security agenda, Japan could be temped to shift its posture and work more closely with ROK on a policy of economic engagement as a means to entice more concessions on the security agenda. This would force a major rethinking of U.S. policy and have repercussions on the "virtual tripartite alliance." If on the other hand, DPRK decides to go down the reform road and opens up further to the international community, the question for future U.S. policy will be whether to let Japan take the lead in engaging the DPRK leadership in economic rehabilitation programs and providing the bulk of financing required in cooperation with ROK, or to try to exert direct influence through bilateral economic dialogue and assistance. In any case, the U.S. will need to become more explicit about how it sees economic reconstruction progressing in DPRK and how the U.S. role will be defined in relation to Japan, which is likely to provide significantly greater investment and aid than the U.S. in any scenario.

Regional Economic Cooperation. The future of Northeast Asia is being significantly shaped by energy security and economics. The industrialized economies of Japan, ROK and eastern China are major importers of energy and are increasingly looking to Russia as a strategic energy partner for the future. Regional oil and gas trade is now moving beyond the stage of studies to reality. Building new regional mechanisms to promote and protect these strategic interests are becoming an increasing priority for the countries of Northeast Asia, and this is likely to influence the course of both security and economic cooperation in the region. Moreover, with China's accession to the World Trade Organization, trade and investment relations with its neighbors are becoming an increasing area of focus. China, ROK and Japan have already moved to set up coordinated research and policy dialogue on these areas. As Russia has moved beyond its economic turmoil of the late 1990's, economic relations with its Asian neighbors are also being given increasing attention in Moscow as well as in the Russian Far East, and Russia's relations with both China and Japan have improved significantly recently in part because of the draw of deepening economic cooperation. ROK and DPRK both are pursing deepening economic ties with the Russian Far East as well. Furthermore, environmental as well as economic interests are drawing the countries of Northeast Asia closer together in cooperative activities, especially in air and water pollution. An essential policy question for the U.S. is how to relate to these emerging regional perspectives and dynamics, which are not driven by the same factors that have governed relations among the countries following World War 2 and the Korean War. In fact, the war on terrorism has added incentives to accelerate Northeast Asia regional economic cooperation to offset perceptions of increased risks of disruption in energy supplies from the Middle East and Indonesia, and concerns about hedging the downside risks of disruptions in global markets more generally.

DPRK fits into the emerging regional energy equation for a number of reasons. One is that DPRK's economic situation is deeply affected by the lack of energy and any economic rehabilitation program will need to give high priority to rebuilding DPRK's energy sector. Cross-border energy relations will be an important dimension of any future strategy. A second consideration is that gas trade in Northeast Asia may be handled by cross-border pipelines rather than relying on LNG transported by ship. Several gas pipeline projects have been proposed to meet ROK and China's future gas demand, and the prospect of a pipeline crossing DPRK to serve the ROK market offers important opportunities to integrate DPRK in a regional gas market and to participate in projects that can address DRPK's own energy needs along with those of ROK. A third consideration is that creating a system of regional economic cooperation that is founded on energy interdependence could have important repercussions on the more general security architecture, and a policy to include DPRK in an interdependent regional system would have critical political implications for relations of neighboring states with DPRK. This aspect of a possible gas pipeline that crosses the Korean peninsula needs to be made more explicit in future discussions of energy cooperation in the region. A fourth and related consideration is the link of future energy cooperation with a future mandate for KEDO. While KEDO was created as a political organization designed primarily to achieve nuclear non-proliferation objectives, the light-water reactor project necessarily engages the practical issues facing the energy sector both in DPRK and regionally. These linkages cannot be ignored in the future if KEDO is going to continue to exist and have a mandate to complete construction of the reactors or a modified investment package that might emerge from negotiations about restructuring the Agreed Framework to include realistic and meaningful energy and economic objectives.

While energy is the main strategic driver for future economic cooperation in Northeast Asia, it is not the only area of potential. Transport links and expanded trade among the countries are also receiving increased attention. In particular, the proposed rail link across the Korean peninsula to Russia is receiving a great deal of attention and now figures in both the regional and inter-Korean dialogue for expanded cooperation. While the economics of the rail links may prove worthwhile to pursue, the implications for economic integration and interdependence are much less significant than the energy agenda, because the backward linkages are limited. A combination of rail, road and sea transport links between the two Koreas is important more from the perspective for deepening bilateral economic ties than the regional perspective.

A question for the future U.S policy stance towards an expanding Northeast Asian economic cooperation agenda, is whether the U.S. sees its vital interests as engaged in these activities and participates in a robust way, or whether it takes a back seat to processes and policy leadership that are lead by the countries within the region. In any case, China can expected to take an increasingly active role in shaping the sub-regional agenda, as it is now in the ASEAN +3 context. U.S. policy towards North Korea in the future will need to be set in the framework of a broader policy perspective on U.S. interests with regard to expanding Northeast Asia regional economic cooperation. Important considerations include: potential long-term business opportunities for American companies, implications for diversification of U.S. imported energy supplies, and implications for regional security of deepening economic interdependence in Northeast Asia.

International Financial Institutions (IFIs). DPRK is not a member of the International Monetary Fund (IMF), World Bank, or Asian Development Bank (ADB). Because the U.S. is a major shareholder in all three institutions, its policy regarding relations between DPRK and the IFI's is widely perceived as a critical precondition for these relations to advance beyond merely educational engagement. Nevertheless, both ROK and Japan also have a major voice in future IFI relations with DPRK and it will be important to avoid conflicts between the U.S. and its allies in this area. ROK has already stated publicly on numerous occasions its desire to see DPRK develop relations with the IFIs, and has been frustrated by the U.S. intransigence. While Japan is not advocating early development of IFI relations, its attitude will be significantly affected by progress in normalization of relations talks with DPRK. When the economic assistance package that Japan is holding out for DPRK becomes a reality, it will be greatly in Japan's interest that DPRK be under the scrutiny of the IMF and to use the development banks as multilateral conduits for a portion of its assistance to help bring needed transparency and oversight into the use of funds provided to DPRK for economic development purposes. An important policy question for the U.S. will be whether to rely on the IFI's to take the lead in economic reform policy dialogue and institution building for a transition to market economy, or whether to add this agenda to an already heavily burdened bilateral relationship.

Assessment of U.S. Policy on Economic Cooperation

U.S. policy towards economic cooperation with DPRK has been essentially tactical and limited to the objective of containing DPRK's Weapons of Mass Destruction (WMD) programs and maintaining a overwhelming superiority in conventional deterrence capability on the peninsula. Tangible economic cooperation beyond humanitarian aid has not figured in American policy thinking, even under the Clinton Administration. It is notable that there has been no American involvement or vocal and unambiguous expressions of support for any of the inter-Korean economic cooperation initiatives undertaken since the Summit of 2000. The ambiguity cited at the beginning of this paper reflects this preference not to extend assistance to DPRK in a situation where it must also be recognized that both ROK and Japanese policy is to promise substantial economic cooperation if their core interests are being addressed.

In the short term, policy of the Bush Administration will most likely be to maintain economic pressure on the DPRK leadership to achieve a regime transformation that will meet U.S. goals on reducing military threats. The presumption is that a further weakening of economic conditions reinforced by suspension of KEDO oil shipments coupled with cutbacks on humanitarian assistance and interdiction of missile exports will either force the DPRK leadership to accept the need for change or add to pressure for internally induced changes. The requirement for prior action by DPRK on the nuclear program issues before the U.S. is willing to talk about a non-aggression pact or economic assistance, in effect is a requirement for the DPRK leadership to "cry uncle" and concede to American will. This economic strategy is not without risk, however, and it can be expected that the DPRK leadership will press the limits of tolerance of support for U.S. policy by other countries and at the same time seek to re-establish economic security through measures that do not require acquiescence to externally induced pressures. The home grown economic reform initiatives and efforts to build bridges to the ROK, Chinese and Japanese economies must be seen in this light. So should reports that DPRK is now working on a new 10 year economic development plan for the first time since the early 1980's.

A U.S. policy of applying increasing economic pressure will only work if it is actively supported by all of DPRK's neighboring states and if DPRK's economic reforms backfire. At present, none of DPRK's neighbors are willing to risk the prospect of armed conflict or massive refugee flows, so there are clearly limits to their willingness to stay the course with present U.S. policy if DPRK succeeds in strengthening its economy and bargaining position by its own efforts. It is important to assess both the upside and downside potential of this policy. If DPRK capitulates and takes the desired steps to address U.S. nuclear and other security concerns, active U.S. support for economic advice, technical assistance and rehabilitation initiatives could lead to a very positive dynamic of change. If DPRK demurs and succeeds both in driving a wedge between U.S. interests and those of it neighbors, and in strengthening its economy, then U.S. policy will face an uncomfortable quandary. At stake are not only US. interests regarding DPRK's WMD programs, but also longer term interests in its relations with ROK, Japan and China.
While it may be reasonable to expect that DPRK's economic reform initiatives will backfire, given the lack of knowledge and skills for designing and implementing a comprehensive reform program in DPRK, it may well be that DPRK succeeds in making sufficient improvements to sustain the modest economic turnaround that seems to have taken place since 1998. Moreover, inter-Korean economic cooperation could easily be expanded to include a component for economic policy advice and technical assistance, enabling DPRK to achieve tangible economic gains and thereby avoid U.S.-inspired economic pressure to force change in its WMD policy.
The Russian factor is also important. While not presently a major trading partner with DPRK, Russia has both a stake in the future regional economic cooperation agenda and a role to play in integrating DPRK in the regional energy economy. U.S. cooperation with Russia on both security and economic policy towards DPRK has grown significantly in recent months and could become even more important in the future. Maintaining Russian support for the U.S. policy of pressuring DPRK to make concessions on its WMD programs will be critical is this policy is to work, but equally important will be Russian participation in eventual political and economic assistance agreements that will guarantee DPRK's security and future economic prospects.

Recommendations for Future U.S. Policy

In the medium and longer term, U.S. interests are going to be best served by a DPRK that is:
· Not militarily threatening to its neighbors and international community,
· Economically literate,
· Pursuing a managed transition to a market economy,
· Deepening economic ties with ROK through investment, trade and infrastructure links between the two countries, and through gradual harmonization of legal and financial institutions, and
· Increasingly integrated in the Northeast Asian regional economy and international economic system.

U.S. policy should be geared to achieve these outcomes, which will require shifting from a military-centered approach to maintaining stability and security on the Korean peninsula and in Northeast Asia, to one that incorporates an explicit economic dimension driven by increasing economic interdependence among the countries in the region and an economic reform orientation in DPRK. A policy of positive economic engagement that complements a policy of seeking a permanent peace on the Korean peninsula and resolution of WMD issues of concern should form the core of future U.S. policy. Trying to use economic pressure to force political change in DPRK should be abandoned in favor of a policy that seeks to harness the already active forces of economic change in a staged way to impel future political change and incentives to reduce security barriers to expanded economic prosperity.

Specific elements of such a policy should include in a first stage:
· Explicit statements of support for inter-Korean economic cooperation activities, including legal agreements, cross-border infrastructure links, and the Keasong industrial zone project, coupled with willingness to enter into dialogue about issues relating to U.S. laws and regulations that might affect the success of these ventures. Actual delivery of regulatory changes or other positive steps could be linked to progress in reaching agreements on specific security issues.
· Strong rhetorical support for DPRK economic reform efforts and recognition of the risks that these also raise. Initial funding should be allocated for an initiative to support training of North Koreans in economics, trade and other fields in American universities, along the lines of U.S. programs for ROK and Thailand in the 1960's and 70's and more recently with China and Vietnam. Expansion of the program could be tied to progress on security issues.
· Support for immediate involvement of the IMF and multilateral development banks in reviewing DPRK's economic reform strategy and program and providing advice and technical assistance to help DPRK design and implement a realistic reform program, even before the formalities of membership are completed. Support for membership and associated lending programs could be linked to completion of normalization of relations negotiations with Japan and progress in reaching agreements on specific security issues.
· Seek to rationalize the KEDO mandate and light-water reactor program to make these more directly related to providing economically efficient solutions to DPRK's energy sector rehabilitation needs, including consideration of dropping the nuclear reactors in exchange of an energy package that includes conventional power production and rehabilitation of the power grid. A gas option linked to regional gas trade proposals should be explored with Russia possibly joining KEDO as a member. Agreement to proceed with such a restructuring of KEDO should be an integral part of the strategy for resolving the WMD issues in a sustainable form.
· Actively participate in regional economic forums and development of new institutional arrangements designed to promote expanded trade and investment among all the countries of Northeast Asia, with DPRK included in the regional economic cooperation framework.
In the medium term, U.S. policy should be to support and actively participate in a multilateral effort to help DPRK manage its transition to a market economy and join the international community as an accepted member. The IFI's should be encouraged to open resident offices in Pyongyang and a forum for donor consultations with both DPRK and ROK should be created to provide a mechanism for coordinating economic assistance policies to support both the economic rehabilitation of DPRK and integration of the two Korean economies. The U.S. should participate as one among many donors to this effort, through bilateral and multilateral contributions. The U.S. should also actively participate in the future energy cooperation agenda for Northeast Asia, both by encouraging involvement of American oil and gas companies in energy projects and in participating in inter-governmental meetings designed to address cross-boundary legal and financial policy issues that require multilateral consultation and agreement.

A Footnote on Crisis Management. This paper was drafted for circulation to the Task Force on the eve of the ROK election and in the midst of an escalation of confrontation over DPRK's nuclear program. At this juncture, it appears that the DPRK leadership has opted for crisis engagement instead of acquiescence to American demands that it take unilateral action to dismantle its nuclear program in a verifiable manner. It is important that in any crisis management response, policy and action are shaped with a realistic appreciation of the economic dynamics that are influencing DPRK behavior and potential role for economic actions in a peaceful resolution of the crisis. What should be avoided is the outcome of the Agreed Framework negotiations of 1994, which created an economically irrational mechanism for achieving the political goals, leaving the political achievement ultimately unsustainable.

Bradley O. Babson
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December 18, 2002 11:04 AM