Estimation of Benefits and costs of Kore’s unification: A critical Review

There exists a wide range of estimates on the costs of unification from Korean and foreign economists. After the process of German unification following the collapse of the Berlin Wall in 1989, economists commenced studying the costs of Korean unification in the 1990s. Lee (1994), Jung (1996), and Noland et al. (1997) are examples of early studies. Many studies were undertaken over the past decade, but no progress was made in the methodology of estimation.

Most of these previous studies contain estimation problems through their failure to consider the method of unification, unification processes, and the dynamic development of an integrated economy (Lee and Kim, 2012). The wide range of estimated costs in itself has made Korean people more pessimistic toward unification, apart from the generally high estimates themselves. For example, drawing from the experience of the German unification process, Choi (2011) estimated that 10-12% of South Korea’s GDP would be required for 10 years after unification to raise the income level of North Korean people to 80-90% of that of South Koreans.

The total cost estimated by Korea Development Institute (KDI, 2010) was US$322 billion for 2011-2040 under the assumption of a gradual unification, which rises to US$2 trillion 140 billion for 30 years after unification should North Korea collapse suddenly. Wolf (2010) estimated US$1 trillion 700 billion to be expended in improving the North Korean economy to a stage similar to that of South Korea and US$62 billion in doubling North Korea’s per capita income. The estimates by Beck (2010) were US$2 trillion in increasing North Koreans’ per capita income to 80% of that of South Koreans over 3 decades, which rises to US$3-5 trillion in the worst case.

Kim (2014) presented a more elaborate and balanced argument in estimating the costs of unification by considering the likely benefits from expanded markets due to an integrated economy and a boom in economic activity over time after unification, although chaotic social and economic conditions are inevitable. Kim and et al. (2008) analyzed the dynamic evolution of transitional countries after the collapse of the Berlin Wall, arguing that more detailed research on the process of such transited economies is required, and that economic reform and liberalization in North Korea will be key in reducing the costs of unification and smoothing the unification process.

Most of the existing economic studies regarding inter-Korean unification are estimations of the costs of unification benchmarked by the experience of German unification. Depending on the assumptions made as to the unification scenario and economic data for North Korea, estimates of the costs of unification range from US$73.2 billion (Lee, 2003) to a maximum of US$5 trillion when assuming a war such as in the case of Yemen (Beck, 2010). However, recent studies present the benefits of unification as outweighing the costs. Goldman Sachs (2009) reports US$1 trillion gains for South Korea based on the synergistic effects of South and North economies after unification. Sung (2014) estimates that unification would bring 16%p GDP growth for North Korea during 2016-2030 annually and 1%p GDP growth for South Korea in the same period.

The benefits and costs of unification will be substantially different depending on critical factors such as the method of unification. In the case of a sudden collapse of North Korea, it is not easy to pre-estimate the costs of unification, since the situation after collapse is not foreseeable and could be changed by several factors. Economic problems such as a shortage of necessities will be a basic issue, but many social and political problems including refugees will emerge. Although previous experiences such as German unification can act as a reference, it is difficult to imagine that a similar unification process will occur in Korea.

Although unification is one of most important values for Koreans, an economically efficient transition is desirable for the Korean people as well as the whole Korea, considering the burden of unification costs from chaos and the current economic situation, which is growing slowly. The fact that there is no consensus as to the estimated costs of unification makes it difficult for Koreans to judge the value of unification. While the many factors involved in estimating the costs of unification under various scenarios render the process complex, a lack of information about the North Korean economy has been a major reason for the lack of progress in estimating the costs of unification.

Although optimistic prospects for unification have been raised recently, these estimates are substantially affected by the unification scenarios. No concrete data and information on the economy of North Korea are available. Unification and economic integration require a long-term process to be implemented in stages. German unification has taken longer than two decades, and it is indeed still in progress. Thus, Korean unification cannot be accomplished all at once; it demands a substantial length of time and extensive diplomacy. Sung (2014) assumes that many young men will be discharged from the military forces of both Koreas and they will reinforce the labor supply in industrial sectors, contributing to economic growth. However, the study does not investigate whether the industrial base in North Korea has the capacity to accommodate more workers in terms of aspects such as technology, logistics, energy, and markets.²⁾

Whether North Korea has the capacity to produce marketable products is not clear. How rapidly the North Korean economy can be transformed into a market system will be a critical element in determining the benefits and costs of unification. More specifically, in order to export products, North Korea will require access to foreign markets. The assumption is made that if South Korea’s economic system and practices are extended into North Korea, and all their legal and economic systems are integrated after unification, no trade issues regarding exports by North Korea will arise. This is too optimistic and is not realistic in many aspects. Social and political turmoil will work against the benefits of unification. It should be emphasized that unification cannot be realized overnight and that no “master plan” prepared in advance will be workable.

Economic integration preceded political integration in Germany. Immediately after Germany was divided into East and West, both parties began to trade with each other under the heading of internal German trade; production cooperation began00 in 1960. Negotiations were undertaken 34 times on science, technology, culture, environment, among others, during the 15 years between 1972 and 1987. East Germany was one of the more advanced industrial countries of Eastern Europe and had well-trained human resources. The per capita income of East Germany was US$6,749, the highest recorded among socialist countries. Industrial bases in East Germany were organized in provincial administration units (Kombinat) and goods produced under the socialist planning system were allocated through a distribution system (Handelsorganisation). East Germany’s international trade was divided between socialist countries and market economies in the ratio 2:1, and more than 90% of its overall trade was with Russia (Soviet Union) and West Germany. West Germany accounted for the lion’s share of East Germany’s trade with market economies, but its dealings with East Germany comprised less than 2% of West Germany’s total trade. As its neighboring socialist economies worsened and trade deficits widened, East Germany came to depend more heavily on West Germany.

Although Germany spent US$2 trillion for its unification, it was able to save costs due to favorable international conditions when the Berlin Wall collapsed, since the economic system of East Germany was similar to that of a market economy due to its support by West Germany. It is difficult to accept that Korea should anticipate such a situation will exist. Before the World Trade Organization (WTO) was launched in 1995, multilateral trading rules were generally much less stringent under the General Agreement on Tariffs and Trade (GATT) than that of the WTO. External economic issues will certainly be raised by foreign partner countries and international organizations such as the WTO. No one can be sure that South Korea’s international status, such as WTO membership, will automatically be extended to North Korea. In many aspects of international trade, the current situation for North Korea is thus different from that of German unification, where the economic system of East Germany was almost compatible with GATT through its support by West Germany, although the former was a socialist country.

It is worth discussing North Korea’s economic laws, focusing briefly on their non-market elements. As a socialist country that is controlled by the planning agency in a central party, North Korea does not have a systemic legal infrastructure and the degree of codification of its common law is low, compared with other countries. Its laws have the characteristics of symbolic declarations that do not target rulings for specific cases. Moreover, guidelines laid down by its leaders are regarded as the highest rules for citizens and government officials; the laws can thus effectively be changed by remarks made by these leaders. This implies that North Korea’s system of rule violates the principle of constitutionalism. The fact that its laws are regarded as political measures is likely to damage the objectivity and fairness of its legal system in terms of constitutional rule.

The legal framework governing North Korea’s external economic affairs comprises 54 laws including regulations for foreign investment, economic zones, customs, economic contracts, trade processes, rules of origin, and intellectual property rights.³⁾ Although it has a legal system for external business, many elements of its laws are incompatible with those of a market system. The North Korean economy is based on a planned economic system (Article 34 of the North Korean constitution), with which its laws on trade abide. Trade contracts are made according to the planned economic system (article 5 of the law on trade) and the government is supposed to mediate all international trade. While private economic activity is permitted domestically as a small part of the North Korean economy, international trade is only permitted by governmental agencies or organizations and not by private people. In addition, private companies are not permitted in North Korea. Based on these facts, it can be said that North Korea’s legal system is fundamentally different to a market economic system with regard to international trade.

It is possible for researchers to estimate the costs of unification using several approaches that range from a target income method to a computational general equilibrium (CGE). An example of a simple approach would be to set a target income for the North Korean people, with additional considerations for building basic infrastmcture in North Korea. Estimates of this kind can be found in Beck (2010), Choi (2011), and Lee and Kim (2012). Studies of Korean unification costs using a CGE model include those of Noland (1996), Noland and et al. (1998), Korea Institute of Unification (2011), and KIEP (2014).

KIEP (2014) tries to incorporate aspects such as the growth of production factors (land, labor, and capital) and market expansion due to unification using a CGE model. In case of labor, the study assumes that more workers will be available due to a reduction in the number of military personnel, leading to an improvement in the productivity of North Korean workers when the two countries are united. The study adopts several scenarios in which the North, as part of a united Korea, joins several free trade agreements (FTAs) including the Trans-Pacific Partnership (TPP). It predicts that Korea will enjoy about 3% GDP growth 20 years after unification, supporting the current government’s proposition that unification will be beneficial for the country, although the estimates obtained do not show “economic jackpot”.

Since KIEP is a national think tank that supports policy formulation and collaborates with policy makers, the impact of its findings on a specific issue tends to be critical in Korea. Since Goldman Sachs (2009) reported that unification would bring significant economic gains for Korea rather than a burden in supporting the North Korean people, Korean opinion leaders became interested in the background for Goldman Sachs’ optimistic viewpoint. Goldman Sachs (2009) projects that: “The GDP of a united Korea in USD terms could exceed that of France, Germany, and possibly Japan in 30-40 years, should the growth potential of North Korea, notably its rich mineral wealth, be realised.” (Goldman Sachs 2009, p.1) “We [Goldman Sachs] believe that the integration costs of South and North Korea could be reduced to an affordable level, if backed by appropriate polices … We estimate that output growth and currency appreciation under the flexible rate regime, together with annual transfers of 1% of GDP from the South, could shorten the time needed to reach half the income level of South Korea to 13 years” (Goldman Sachs 2009, p.20), as illustrated in Figure 1.

Figure 1. Illustrative scenario of a North-South income convergence (Number of years for North Korea’s per capita income to reach half of the South Korean level) Source: Modified from the Exhibit 24 (p.20) of Goldman Sachs (2009)

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This optimistic conclusion was based on four main factors: (1) North Korea’s labor force, (2) economic cooperation with South Korea, (3) economic gains from the transformation from a planned socialist system to a market economy, and (4) the growth potential of the mineral sector. The most critical element of these is the calculation of the benefits of unification in the mineral sector, achieved by breaking the economy of North Korea down into a mineral sector and a non-mineral sector.

The report states, “We convert the mineral wealth to financial assets equivalent to its NPV [net present value]. This effectively means that North Korea sells the mineral wealth to strategic investors at the NPV price and invests the proceeds in long-term bonds. We assume 3% inflation-adjusted annual returns from the bonds through to 2050. We also assume that North Korea earns 15% of mined minerals as wages paid by strategic investors.” This represents Goldman Sachs’ financial approach to Korea’s unification as an international investment bank; it lacks a consideration of the structural problems in North Korea’s industry and trade and ignores the prospect of changes in world mineral prices. Moreover, the Goldman Sachs report ignores the fact that economic gains compared with extraction costs differ across natural resources. In most cases, higher returns have been made for petroleum and gas, with poor performances for minerals such as manganese, zinc, and lead, in which North Korea is rich.

Considering the high costs of extraction, the low quality of minerals and ores, and the poor logistics infrastructure in North Korea, it was reported in KDI (2013) that the value of natural resources and labor forces was being overestimated. KDI (2013) states that “North Korea has rich mineral resources, but researchers can recognize that the value of these has been overestimated when more detailed assessment is made. It can be concluded that the development of natural resources cannot be a leading growth sector in North Korea, even though it has a high reservoir” (KDI 2013, pp. 9-10), here criticizing the argument of Goldman Sachs (2009, p.1) that “The conceptual framework is to convert the mineral wealth to financial wealth and estimate three sources of income: the converted financial assets, their investment returns, and wage income from mineral extraction.”

Compared with Goldman Sachs (2009), KIEP employed a recursive CGE model that can incorporate industrial structures and trade issues including joining several FTAs under various scenarios. While the CGE model has many merits as an economic forecasting model, it requires a great deal of data and parameter information in running simulations. The heart of CGE estimation is the input-output (IO) table on which researchers base the analysis, with trade models incorporating the IO tables of all the relevant economies.

It seems that the KIEP researchers had problems in setting up the North Korean economy in the CGE model since North Korea has not published its IO tables and there is very limited information on its economy. KIEP adopted version 8.1 of the Global Trade Analysis Project (GTAP) database, which Purdue University has maintained since 1991. The GTAP database covers 129 countries/regions/economies, but North Korea could not be included. Because of this, KIEP needed to choose a country that is similar to North Korea in economic size and industrial structure.

According to KIEP (2014), Tanzania could be chosen as a proxy for the economy of North Korea, since the country is similar in economic size to North Korea and its major industry is the mining sector. However, KIEP (2014) tried to prepare a better proxy by selecting “Rest of East Asia” in the database, assuming that this region implicitly covers Macao and North Korea. KIEP (2014) wrote, “Since the economic size of Macao is small and the country trades heavily with China, most of Rest of East Asia in the GTAP database could be regarded as North Korea.” However, the industrial structure of the Rest of East Asia is quite different to that of North Korea (Table 3) as estimated by the Bank of Korea in 2014. In addition to this, the GDP of the region is more than two times that of North Korea, which is about US$30 billion as of 2013.

Table 3 was calculated from data on industrial structures in the GTAP for Rest of East Asia, Korea, China, and “Other Developing Countries” for reference. The share of agriculture, forestry, and fishery of the Rest of East Asia is lower than that of China and Other Developing Countries, while that of other services including sales, food and lodging, transportation, real estate, telecommunications, banking, and insurance is much higher than that of Other developing countries. The point that Rest of East Asia cannot be equated with North Korea becomes clear when comparing the share of industries in Table 3 with the estimations made by the Bank of Korea as seen in Table 4.