NORTHEAST ASIA PEACE AND SECURITY NETWORK ***** SPECIAL REPORT ***** August 4, 1999 The following are excerpts from a study on the economic aspects of Korean unification, by Marcus Noland of the Institute for International Economics; Sherman Robinson of the International Food Policy Research Institute; and Tao Wang of the Institute for International Economics. The authors attempted to construct a model of possible economic integration between the ROK and the DPRK, leaving aside the question of political unification. They concluded that an economic integration would have an enormous impact on the DPRK economy, while in the ROK it could cause major changes in the distribution of income. The full paper, including data tables and references, is available in pdf format at: http://www.iie.com/CATALOG/WP/1999/99-7.pdf ------------------------------- MODELING KOREAN UNIFICATION Marcus Noland Institute of International Economics Sherman Robinson International Food Policy Research Institute Tao Wang Institute of International Economics June 1999 Copyright 1999 Institute for International Economics. INTRODUCTION The North Korean economy has been in decline for the better part of a decade. Under duress, the current regime has undertaken some modest reforms, but these have not fundamentally altered the centrally planned character of the economy and are unlikely to reverse the economy's downward spiral. In one poll of scholars, 38 percent of the respondents predicted that the current regime would not last a decade (Y.S. Lee, 1995). In a more recent poll, the respondents' mean subjective probability of collapse was 26 percent, while the mean estimate of significant reform was 40 percent (Noland, 1998, Table 1). One obvious direction of reform would be marketization of the economy and openness to greater interaction with the outside world -- including South Korea. Greater North-South economic integration, either in the context of a reform strategy initiated by the North or in the context of collapse and absorption by the South, potentially could have profound effects on both economies, yet scant effort has been devoted to constructing economic models to analyze this possibility. In this paper, we start from incomplete data ridden with gross measurement errors and, using cross-entropy estimation techniques, construct the underlying data base for a computable general equilibrium model (CGE) of Korean economic integration. This estimation approach is powerful and flexible, allowing us to make full use of what information we have in whatever form. CGE modeling forces internal consistency. The end product, the Korean Integration Model (KIM), is a two-country CGE model linking the North and South Korean economies. The model incorporates fragmentary information in a rigorous way and allows us to examine the implications of a number of alternative integration scenarios, extending previous studies of integration by Noland, Robinson, and Liu ((NRL) 1998, 1998) which used an earlier version of KIM. The new KIM is an updated version of the earlier model described in NRL (1999). The NRL studies developed an eight-sector, four-factor, constant-returns- to-scale CGE model of the North and South Korean economies calibrated to 1990, the most recent year before North Korea entered a period of severe macroeconomic instability. These studies concluded that the extent of cross-border factor mobility was key. If the two countries formed a customs union, freeing cross-border trade in goods, but not in factors, the macroeconomic impact on South Korea would be slight. In contrast, the impact of economic integration with the North on the South Korean economy would be non-trivial once restrictions on cross-border labor and mobility were removed. In particular, there would be a shift in the South Korean distribution of income toward capital, and within labor toward urban high-skill labor, suggesting increased income and wealth inequality in the South once capital began flowing North and labor began flowing South. However, under one scenario, the present discounted value of the South Korean income stream under integration actually exceeded the baseline no integration figure, indicating that the South Korean economy as a whole could be better off with integration and also indicating that, with proper redistribution, economic integration of the Korean peninsula could be Pareto-improving -- everyone would be better off. This result crucially depended on two modeling assumptions, however. First, the form of capital transfer from the South to the North had to take the form of profit-making investment which yielded a stream of remitted profits to Southern investors. If the transfers were modeled as grants, capital earnings would remain in the North, and the possibility of economic integration that would benefit the South relative to a no integration baseline would disappear. The result also depended critically on the rapidity of technological convergence between the North and the South. In the potentially Pareto- improving case, the North adopts South Korean technology over the a decade, attaining not only Southern levels of total factor productivity (TFP), but the Southern input mix as well. In this paper, we extend that earlier work in two principal ways. First, conditions on the Korean peninsula have changed considerably since 1990 (the date of calibration of the earlier models), most obviously with the emergence of a famine in North Korea. Economic distress has forced North Korea into greater openness, and as a consequence, more information about the North Korean economy has become available. The United Nations Development Programme (UNDP) has been working with the government of North Korea to construct standard national accounts, and some of these data were released to an IMF mission that visited North Korea in 1997 (IMF, 1997). Other international bodies such as the Food and Agricultural Organisation (FAO) and the World Food Programme (WFP) have released data associated with their famine relief work. This newly available information has made it possible to extend and recalibrate the earlier North Korea model to 1996, reflecting North Korea's changed circumstances. In particular, it is now possible to examine the impact of economic integration on the North Korean famine. It is also plausible that the process of economic integration could be accompanied by political rapprochement or unification. We consequently examine the potential for a "peace dividend" associated with military demobilization. These issues can be usefully examined in a comparative static framework. Some issues are inherently dynamic, however. Cross-border investment and technological change will not occur instantly, so the speed of technological convergence is a critical issue. Barro and Sala-i-Martin (1992, 1995) present evidence that countries with low initial levels of per capita income tend to exhibit higher per capita income growth than countries with initially higher per capita income levels. That is to say, there is a tendency toward per capita income convergence. Indeed, Barro and Sala-i-Martin argue that in a variety of contexts (among US states, among members of the OECD, among all countries) there is a tendency for poorer regions to converge on the incomes of richer regions, conditional on other factors, at a rate of roughly two percent annually. Yet this "two percent rule" is probably inadequate for the task at hand. Rather than convergence in the steady state growth paths of regions with at least access to similar production technology, the economic integration of North and South Korea would arguably put North Korea on a new growth path, at least transitionally. Evidence from the German case suggests that the speed of technological convergence between East and West Germany has been considerably higher than two percent annually. Thus in the second part of the paper, we combine the analysis of cross- border factor flows with the literature on intra-German technological convergence to examine the implications of realistic estimates of the speed of technological upgrading for income convergence, the "costs of unification," and the incentives for cross-border labor migration. Having raised the comparison with the German case, it is worthwhile to indicate at the outset some issues that this paper does not address. Given our model's medium-to-long-run orientation, the focus is primarily on sectoral adjustment issues in the context of a simple macroeconomic framework. For two principal reasons we do not address a number of interesting macroeconomic issues, such as exchange rate overshooting, which have been prominent in the literature on German unification. First, the disimilarity of factor endowments is far more pronounced in the Korean case than in the German case (Noland, 1997). As a consequence, integration may have more dramatic sectoral implications in the Korean case compared to the German case. This fact, combined with the far larger differences in economic size between the two Koreas compared to pre-unification Germany, suggests that in certain respects the North American Free Trade Agreement (NAFTA) may be a closer analogue to the prospective Korean situation than the German experience. The KIM is well-suited for examining these integration issues. Second, history does not operate by analogy. There is no particular reason to believe that adjustment issues that arose in the German case, and which were at least partly due to avoidable policy mistakes (such as the wage equalization policy), would occur in the Korean case. Indeed, the Koreans can learn from the German experience and avoid some of the German errors. To cite a specific example, in contrast to the German wage equalization policy, most Korean analysts expect the maintenance of the existing demilitarized zone to control population movements after economic integration and also expect the perpetuation of greatly differing wage structures in the two halves of the peninsula for some extended period of time (cf. Young, Lee, and Zang, 1998). Finally, we should observe that in this paper we simply model a customs union and exchange rate unification; these do not require political unification, just economic integration, and on the political issue our paper is agnostic. CONCLUSION Previous work (Noland, Robinson, and Liu; 1998) examined the possibility of Pareto-improving economic integration on the Korean peninsula. This relatively optimistic result crucially depended on two modeling assumptions. First, it depended on the assumption that the form of capital transfer to the North took the form of profit-making investment, which yielded a stream of remitted profits to Southern investors, and second that technological convergence between the North and the South was relatively rapid. This paper has taken a second look at these issues, using more recent data on the North Korean economy unavailable at the time of the Noland, Robinson, and Liu work, and calibrating the rate of technological convergence in the updated model on the basis of estimates of convergence in the German case. The availability of new data has also facilitated the examination of famine-related issues and the possibility of a "peace dividend" associated with military demobilization which were not addressed in the earlier literature. The main finding of this paper is that economic integration between North and South Korea would have enormous effects on the North Korean economy. Formation of a customs union between North and South Korea, for example, would represent a significant movement toward free trade on the part of the North, bringing with it a variety of benefits. The effects of the ongoing famine, for example, could be ameliorated through this approach. If economic integration were accompanied by military demobilization, the highly militarized North Korean economy would experience a significant peace dividend as well. With regard to South Korea, product market integration would have a trivial impact. However, factor market integration could have a significant effect on South Korea, in terms of the composition of output, the distribution of income, and the rate of economic growth. Depending on the magnitude of capital inflows from the rest of the world (and the degree of real exchange rate appreciation), the nontraded goods sectors could expand at the expense of the traded goods sectors. Assuming that the rate of technological convergence was in the middle range of estimates from the German literature, with gradual equalization of rates of return on capital between the two economies and with a reasonable amount of cross-border migration, per capita incomes in the North would still only reach 55 percent those of the South at the end of a decade. Indeed, under these assumptions, the amount of capital investment necessary to raise Northern per capita incomes to 60 percent those of the South would actually drive the rate of return on capital in the North below that in the South. However, it would be possible to attain the 60 percent target without such equalization of the rate of return in the two parts of Korea under high-end estimates of the speed of technological convergence. This suggests that either the rate of technological convergence would have to be very rapid (say, 12 percent annually), or restriction on migration from the North to the South would have to be imposed on a semi-permanent basis. In South Korea, economic integration with North Korea would generate a shift in income away from labor and towards capital, regardless of whether transfers to the North were considered grants or profit-making investments, and within labor away from low-skill groups and toward high- skill groups. This suggests that absent some compensatory redistribution policies, the process of economic integration would be accompanied by increased income and wealth inequality in the South. Indeed, in the dynamic simulations, high-skilled workers would experience rising wages, while wages paid to lower skilled labor would fall. This paper could be considered an example of rigorous speculation in that we have attempted to bring to bear rigorous technical methods to an important issue where the existent data is fragmentary and in all likelihood error-ridden. We have attempted to avoid spurious precision. What the model documents is that the process of Korean economic integration would involve some significant trade-offs, and we have attempted to document where the "large numbers" would be found. The robustness of the results are obviously an issue in any such exercise, and through the design of our experiments and scenarios, we have attempted to convey a sense of which results are likely to be more robust and which are likely to be less so.