North Korean Political Stability in Play with Enormous Implications for South Korea

Marcus Noland, Institute for International Economics, February 18, 2004.

North Korean economic reforms are contributing to growing social differentiation and inequality, as a "military-first"campaign has been initiated to reinterpret the country's doctrine of juche and to legitimate the reforms and justify a broad-ranging top-down modernization of society. The central issue is whether the current regime can manage this internal change while confronting the implicit legitimization challenge posed by prosperous, democratic South Korea and diplomatic tensions emanating from its nuclear weapons program.

These new developments generate an unusually broad set of possible transition paths and successor regimes. They range from maintenance of the status quo to evolutionary change, probably toward a more conventional form of military authoritarianism, to revolutionary upheaval. The latter in all likelihood would imply the North's collapse and its absorption into the rival Southern state. Recent quantitative models developed by the Institute for International Economics indicate that economic performance critically influences regime stability and that the North's external relations play a central role in this regard. There is now a roughly 5 percent chance of regime change in any given year-half its peak in the 1990s.

Under a scenario of "cooperative engagement," North Korea successfully globalizes: improvements in North Korea's external relations reinforce its economic reforms, leading to a sustained economic revival and a considerable decline in the likelihood of regime change, increasing the prospect for evolutionary change. Under "the neo-conservative's dream" scenario, worsening of diplomatic relations cripple the nascent reforms and a deterioration in economic performance causes a substantial increase in the probability of regime change. In the extreme case, in which North Korea is subject to comprehensive economic sanctions in reaction to its taking actions that would be subject to global condemnation, the probability of regime change reaches nearly 50 percent annually.

A collapse and absorption outcome, along the lines of the German case, would have profound economic and political ramifications for South Korea (and be accompanied by an enormous reduction in poverty in North Korea). Over the course of a decade, the "costs" of unification to South Korea might be on the order of $600 billion. Although remaining positive, economic growth in the South would slow relative to a no-unification baseline and the process of economic integration with the North would likely lead to an increase in income and wealth inequality.

Yet even less apocalyptic, gradual integration, scenarios also pose significant challenges for South Korea. South Korea has considerable problems with nontransparent and corrupt government-business relations. In the North, there is no real difference between the state and the economy. Large-scale economic integration between the North and the South will be by its very nature a highly politicized process and will in all likelihood retard progress in cleaning up business-government relations in the South. Corruption scandals involving the Blue House and the Korean Development Bank with respect to Hyundai Asan's activities in the North are emblematic.

In this context, South Korea should do three things. First, it should commit to the principle that engagement should be conducted on efficient, transparent terms and adopt a tax-based approach to engagement. Second, while engaging, South Korea should prepare for the possibility of collapse in the North by strengthening its economy and improving its internal mechanisms of resource mobilization, allocation, and management. Third, it should accumulate fiscal reserves in anticipation of a possible collapse in the North.

Regardless of its economic progress or policy stance, South Korea remains exposed to the vagaries of North Korean behavior. Financially, South Korea is increasingly integrated into the world economy, creating new vulnerabilities. While it is true that the South Korean stock market actually rose during the 1994 nuclear crisis, the expanded role of foreign participants and the increased complexity of the financial transactions mean that the market today is far less susceptible to political intervention than it was a decade ago.