CONTENTS

I. Introduction

I. Introduction

This special report by Bradley O. Babson, an Asian specialist and former World Bank official, was presented at the 2004 Workshop: "Towards a Peaceful Resolution with North Korea: Crafting a New International Engagement Framework" in Washington D.C. The workshop, which ran from February 12-13, 2004, was hosted by the Korea Institute for International Economic Policy (KIEP) and the Korea Economic Institute (KEI), in cooperation with the American Enterprise Institute (AEI). In this presentation Babson gives an excellent summary of the methods of mobilizing capital for the DPRK. This presentation notes the intricacy of the relationship between political and economic issues in the DPRK. Babson also emphasizes the need for open dialogue between nations to support such an endeavor.

The views expressed in this article are those of the author and do not necessarily reflect the official policy or position of the Nautilus Institute. Readers should note that Nautilus seeks a diversity of views and opinions on contentious topics in order to identify common ground.

II. Essay by Bradley O. Babson

"Designing Public Capital Mobilization Strategies for DPRK"
by Bradley O. Babson

Lessons from the Past In general, the lessons of experience in mobilizing public resources for DPRK in the international community during the 1990's point to the critical tension between political interests of donors and the DPRK leadership on the one hand, and the humanitarian and economic development needs of DPRK society on the other. The tendency to politicize provision of foreign aid is very high, with the consequence of reducing impact on the lives of the DPRK population and distorting incentives for reforms by the authorities.

Subsidized Socialism. It is worth remembering that DPRK built a socialist economic system in which all domestic resources were public and subsidies from the Soviet Union and China were major sources of international assistance for many years. The misallocation of resources and dependency on foreign support that resulted from DPRK's economic management system and political relationships with its Communist backers, contributed greatly to the breakdown of the DPRK economy in the 1990's and the humanitarian crisis that emerged. While espousing the "Juche" philosophy of self-reliance,

DPRK actually built a system that institutionalized economic dependence on foreign public financial assistance, even though this was largely disguised in the form of "friendship prices" and counter-trade practices that provided large subsidies, especially for energy. This dependence, plus the distorting effects of prices that did not reflect economic cost, led to energy-intensive investments in industry, transport, and agriculture that were inefficient and ultimately unsustainable. DPRK's military-first policies and favoritism of the elite amplified these failures, which were not challenged by the suppliers of DPRK's economic aid during this period. The important lessons from these experiences are that the economic policy context is critical for foreign aid to be effective in promoting economic development, and that aid provided primarily for political purposes -- in this case to ensure regime survival -- does not necessarily lead to economic viability and can foster aid dependence that acts as an inhibitor of needed economic reform. There is nothing surprising in this, and it reflects the consensus of international experience with economic development globally.

Korea Peninsula Energy Development Organization (KEDO). The international response to both DPRK's nuclear brinkmanship of the early 1990's and the food crisis of the mid-1990's, essentially resulted in mobilization of new forms of international public financial assistance for DPRK. The establishment of KEDO under the Agreed Framework negotiated in 1994 between the U.S. and DPRK, created a mechanism where public resources from KEDO members (primarily the U.S, Japan, ROK and the European Union) were mobilized to provide both 500,000 metric tons of heavy fuel oil annually to DPRK and construction of two Light Water Reactor (LWR) nuclear power plants. While this agreement broke down following disclosure of a secret uranium enrichment program in October 2002, with suspension of oil shipments in December 2002 and suspension of the LWR project in November 2003, the resources provided by KEDO to DPRK between 1995 and 2003 did accomplish some positive results. On the political side, the KEDO program did contain DPRK's plutonium nuclear program and allowed for direct contacts and negotiations between KEDO members and DPRK during a period of extreme difficulties for DPRK, both in leadership change following the death of Kim Il Sung and in coping with its economic and food crises. These stabilizing factors were important in maintaining peace and fostering an environment where DPRK could build trust with new foreign partners in cooperative activities. On the economic side, the fuel oil did help offset the trade shock that accompanied the collapse of the Soviet Union in 1992, and the LWR project did provide a means to develop practical working modalities for foreigners with DPRK authorities. The LWR project itself, however, was never seen by either side as a truly economic undertaking designed to overcome DPRK's shortages of electric power. Many issues were left unattended as the project developed, including such elementary questions as how to finance transmission lines needed to connect the plants to the national electricity grid and how to stabilize the grid itself to be able to absorb power from the LWRs. With the suspension and likely cancellation of the LWR project now a reality, there is a growing realization (especially in ROK) that significant resources have been deployed without any tangible economic benefit. An important lesson of the KEDO experience is that when public resources are mobilized primarily to achieve political goals -- in this case containing DPRK's nuclear program-- but are provided as economic assistance that does not meet a test of economic or commercial rationality, the political achievement may be unsustainable and the resources essentially wasted. While the demise of the KEDO LWR project may have been triggered by the discovery of the secret uranium enrichment program, it was destined in any case to face a crisis when the lack of economic justification and provision of needed complementary investments could no longer be ignored. A second lesson is that KEDO did succeed in demonstrating the value of multilateralism, both in mobilizing significant public resources from donors with very different interests and in coordinating policies relating to management of these resources and operational relations with DPRK authorities. For this reason, it may well be desirable to consider a future role for KEDO in mobilizing resources for DPRK under a New International Engagement Framework, if it is provided with a new mandate and is better able to integrate its economic and political functions.

Humanitarian Aid. The international response to the DPRK famine of the mid- 1990's also holds valuable lessons for the future. The mobilization of significant humanitarian assistance was accomplished in a disciplined way under the leadership of the United Nations. The annual UN Appeal is based on detailed crop production and food availability assessments by the World Food Program (WFP) and Food and Agriculture Organization (FAO), with health and educational humanitarian needs defined by the World Health Organization (WHO) and UNICEF. These objectively defined appeals have been supported by donors through contributions to UN-managed delivery programs, bilateral transfers, and support for NGO's active in DPRK. The willingness of donors, particularly the U.S., ROK, Japan and European Union, to provide humanitarian assistance while at the same time challenging DPRK on its weapons programs, contributed importantly to a growing perception that it is possible to engage DPRK on multiple fronts at the same time, and that de-linking humanitarian assistance from other issues could create an atmosphere conducive for addressing other concerns of the international community. The fact that DPRK was willing to ask for international assistance and to set up administrative mechanisms to cooperate with foreign partners has contributed to the beginning of a more businesslike way of interacting. While there have been many issues of concern about monitoring delivery of food aid to intended beneficiaries, access to different areas of the country, and restrictions imposed by the government on foreigners working in DPRK, there has been steady improvement over the years, due in part to mutual trust building and in part to learning from experiences.

There are important limitations, however, on the humanitarian resource mobilization experience of recent years. First is aid fatigue. After seven years of appeals for food aid, the willingness of the international community to continue to meet the food deficit in DPRK is dwindling. This reflects both frustration that the more fundamental obstacles to improving food security in DPRK have not been overcome and emergence of new claimants on resources for humanitarian assistance that compete for attention with DPRK, notably in Africa, Afghanistan and Iraq. A second limitation is unwillingness of most donors to shift from humanitarian assistance to development assistance, pending resolution of major political security issues. An initiative by the United Nations Development Program (UNDP) in 1998 to convene a Roundtable for donors and DPRK authorities to discuss an Agricultural Recovery and Environmental Protection program (AREP) failed to mobilize resources needed to address DPRK's underlying difficulties in expanding agricultural production. While the UN and NGOs have made limited progress on a small scale, most governments have not (with the exception of ROK). A third limitation is the recent willingness of some governments to link humanitarian assistance to other political objectives. Since the re-emergence of a nuclear crisis in late 2002, neither the U.S. nor Japan have made credible efforts to respond to the shortfall in the UN Appeal for 2003 and expected for 2004, although official policy is still to maintain a separation of humanitarian aid from other issues. The overall lesson from the humanitarian experience of recent years is that mobilization of significant public resources for DPRK depends critically on political will, and this will cannot be assumed to be stable, even for basic humanitarian needs.

Korean Reconciliation. Political will to mobilize resources for DPRK has been significantly affected by the appeal of inter-Korean reconciliation. The Sunshine policy adopted by President Kim Dae Jung in ROK, led to significant use of public funds to finance inter-Korean projects, including subsidies to private companies such as Hyundai Assan's Mount Kumgang tourism project. The Inter-Korean Economic Cooperation Fund administered by the Ministry of Unification grew from 40 billion Won in 1998 to 1037 billion won in 2002. In the first 11 months of 2003, ROK provided $125 million in direct economic and humanitarian aid to DPRK, while at the same time continuing efforts to resolve DPRK's nuclear program peacefully through dialogue.

However, allegations of under-the-table payments to secure agreement for the June 2000 Summit meeting between Kim Jong Il and Kim Dae Jung, also underscore the risk that public funds can be used in non-transparent ways that ultimately undermine the objectives of reconciliation and distort incentives for DPRK to adopt businesslike practices in its dealing with foreigners. The lesson is that corruption is an issue that can infect the donor as well as recipient and that the risk of corruption playing a major role in use of public resources mobilized for DPRK is high. Strong efforts will need to be made to introduce transparency and safeguards in the mechanisms for both decision-making about the granting of funds and in the use of funds.

Chinese Aid. The experience of Chinese economic support for DPRK in the 1990's also contains important lessons. Since the collapse of the Soviet Union, China has been DPRK's biggest trading partner and largest supplier of concessional assistance, both through subsidized trade and through direct transfers. Chinese agricultural and energy assistance have been vital to DPRK's ability to avoid internal instability that could threaten survival of the regime. China has not chosen to channel resources through the UN Appeal mechanism, and relied on bilateral channels. This permits China to use its assistance to pursue its own political goals independently of the goals of other countries which channel their funds through the UN Appeal. It is widely believed, for example, that Chinese food aid is channeled to the military, which allows the WFP food aid to be targeted at the general population without risk that the military-first policy or regime stability would be undermined by foreign aid policies of other countries.

Cash versus In-Kind. It is noteworthy that most publicly-provided humanitarian aid to DPRK, inter-Korean economic assistance (for example in connecting cross-border road and rail links), subsidized trade with China and the former Soviet Union, and KEDO provision of oil and LWR construction, have not been in cash, but in kind. Cash payments have been made openly by the private sector, but not openly by the public sector, except in the case of protocols negotiated by KEDO under the LWR project, for example for wage payments for North Korean labor. (As mentioned above, allegations of cash payments by the Kim Dae Jung government are considered a scandal.) This preference for in-kind over cash illustrates the lack of trust by external providers of publicly-funded assistance that the DPRK authorities would use funds for purposes intended, and would divert them either to the military or consumption of the elite. Any future effort to address DPRK's large scale infrastructure investment needs will need to involve very different modalities for channeling funds for contracts for civil works, equipments and technical services. The negotiation of protocols for procurement of goods and services as well as supervision of the use of funds will be needed for any future program of development assistance, and will be a major issue for both multilateral and bilateral donors. KEDO experience will be a valuable starting point in these discussions.

Transition to Market Economy. The failures of the DPRK economic system, combined with the limitations of foreign assistance in this environment, are the backdrop for the emergence of the informal market economy in DPRK, as people have sought new means to meet basic needs and responded to incentives to fend for themselves and not depend upon the state. Economic reforms introduced by the government since mid-2002 have accepted that market mechanisms are now playing an important role in the DPRK economy and social system and that market incentives are needed to increase both agricultural and industrial production. Lack of resources to finance needed infrastructure and intermediate inputs has constrained a supply response to those reforms. Thus mobilization of public resources, both domestically and internationally, is critically needed to reinforce the reform process and stimulate economic recovery. The dilemma faced by the international community and DPRK leadership if political developments permit a rationalization of the use of foreign aid for humanitarian and economic development purposes, is how to do this without undermining the positive features of the emerging market economy. Just when incentives are beginning to stimulate entrepreneurship and the taste of freedom in the DPRK population, there is a risk that foreign aid will be used to suit the political needs of donors and the DPRK authorities, and undercut the transformative processes now underway in DPRK. The challenge is to design policies and mechanisms that put publicly mobilized resources to best use in accelerating economic system change and putting the country on a path to prosperity for its citizens.

III. Nautilus Invites Your Responses

The Northeast Asia Peace and Security Network invites your responses to this essay. Please send responses to: bscott@nautilus.org. Responses will be considered for redistribution to the network only if they include the author's name, affiliation, and explicit consent.