RaboResearch - Economic Research

North Korea’s pressure point: the economy

Economic Report

Share:
  • Without China’s economic lifeline, the North Korean economy would go off a cliff
  • Although China has been scaling down on imports from North Korea, which suggest China respects the sanctions imposed by the UN Security Council, China so far has continued to export to North Korea
  • China has strategic interests related to North Korea, which limits the headroom it has in cutting economic ties with its southern communist brother
  • Tensions will remain over the near term and there is always a risk of miscalculation, but we regard an outright war as implausible, given that there is simply too much at stake

With an estimated gross domestic product by the Bank of Korea of USD 28bn and GDP per capita of USD 1,123 in 2016, North Korea is in the top 3 poorest countries on the planet, in the same league as, for instance, Malawi and Niger. Moreover, North Korea is not self-sufficient, which makes it even more puzzling how the country has been able to get so close to obtaining an intercontinental ballistic missile (ICBM), which can carry a nuclear warhead. At the same time, its fragile and dependent economy is North Korea’s most important pressure point. The question is how much room the international community, and especially China, has to crank up economic sanctions and to force Pyongyang back to the negotiation table. Of course, any assessment of the North Korean economy and its dependence on the international community should be taken with a big grain of salt, as North Korea stopped reporting economic data in 1965. Despite the scarce information available, we nevertheless hope to provide more insight. 

Role of China

North Korea has been exposed to sanctions for decades. Over the years, especially China has been providing a lifeline for the North Korean economy. More than 90% of all imports originate from China (figure 1), which provides North Korea with necessities, such as refined petroleum, delivery trucks, food, electronics equipment, medicaments and fertilizers (figure 2). In exchange, North Korea has mainly exported coal briquettes to China (figure 4). Other than that, Chinese companies make use of abundantly available North Korean labour to import clothes or semi-finished products fabricated in North Korea and re-export these to Western countries labelled 'Made in China'. Given North Korea’s weak economic structure and inability to exploit its abundant natural resources on a large scale, it is not able to offer anything else in return, besides coal and iron ore. So, from a Chinese perspective, stability on the Korean Peninsula seems to come with quite a heavy price tag.

Figure 1: Origin of North Korean imports
Figure 1: Origin of North Korean importsSource: Macrobond (2016 data), Rabobank.
Note: ROW = rest of world
Figure 2: What does North Korea import from China?
Figure 2: What does North Korea import from China?Source: UN COMTRADE (2016 data), Rabobank
Figure 3: Destination of North Korean exports
Figure 3: Destination of North Korean exportsSource: Macrobond (2016 data), Rabobank.
Note: ROW = rest of world
Figure 4: What does North Korea export to China?
Figure 4: What does North Korea export to China?Source: UN COMTRADE (2016 data), Rabobank
Figure 5: China’s rising FDI stock in DPRK
Figure 5: China’s rising FDI stock in DPRKSource: Statistical Bulletin of China's Outward FDI

Next to trade, China also has its foreign direct investment (FDI) stake in North Korea. In 2003, China’s FDI stock in North Korea accounted to only USD 1.2mln. Since then, total FDI flows have been accumulating to a total Chinese FDI stock in North Korea of USD 612mln in 2014 (figure 5). Given the small scale of China’s FDI stock from a macro perspective, there is a considerable chance China would be willing to accept a full write-off of its North Korean assets, if this option would provide Beijing with more leverage over Pyongyang in the current political crisis. Moreover, North Korea has not kept its end of the bargain in mutual investment projects up, given the example of the unfinished bridge over the Yalu river, which was planned to enhance trade (and investments) between China and North Korea.

Another incentive for China to retreat from its North Korean interests are the targeted US sanctions on Chinese financial institutes. China’s city of Dandong, for example, is an important city for cross-border transactions between China and North Korea. As a result of Trump’s growing frustration with the lack of progress from China’s side to get Pyongyang back in the box, unilateral sanctions against China’s Bank of Dandong were imposed late June of this year. The US Department of Treasury even called China's Bank of Dandong a “foreign financial institution of primary money laundering concern”. 

Has China followed up on the sanctions?

By providing aid to North Korea, China has prevented the economic system from going off a cliff and at the same time was able to keep Pyongyang on a leash. However, with the North Korean regime increasingly behaving highly erratic, Beijing has been put under pressure by the international community to cut economic ties. Last year, the UN Security Council passed two resolutions (2270 in March and 2321 in November) which directly target North Korea’s economic activity, including a cap on coal export. In August of this year, new sanctions in Resolution 2371 have been adopted unanimously, which step up restrictions on North Korean exports even more. North Korean coal and iron ore are now completely banned, and also sea-food exports and the use of North Korean workers have been constrained.

These sanctions could potentially be devastating for the North Korean economy, as they significantly affect its trade and investment flows, and depressing economic growth. Calculations by Lee and Pyun (2016) show that stricter trade sanctions, such as the ones recently adopted by the UN, could lower North Korean GDP growth rate by roughly 2 percentage points per year. This would put the economy in a severe economic downturn, given that North Korea’s GDP hovered between -1 and 2%[1] over the last ten years.

Figure 6: North Korean exports to China dropped dramatically
Figure 6: North Korean exports to China dropped dramaticallySource: Macrobond, Rabobank

So, have these sanctions already shown their desired effect? High frequency monthly trade data illustrate that exports from North Korea to China have dropped markedly since the beginning of this year (figure 6), which indicates that China is respecting the international sanctions. However, it remains uncertain if all sanctions are fully implemented, which is necessary to reach maximum impact. There are indications that coal imports from North Korea have dropped, but at the same time Chinese iron ore imports from North Korea have surged in the last couple of months, according to the Korea International Trade Association (KITA) based on Chinese customs data. More importantly, Chinese exports to North Korea have been growing over the last couple of months (figure 6). This suggests that China is not willing to economically cut North Korea loose.

Footnote
[1] Estimates by the Bank of Korea, as reported by Bloomberg last July.

Thinking ahead: China’s strategic interests in North-Korea

So, if the economic relationship between China and North Korea looks like a costly one-way street, and economic sanctions oblige China to scale down on its economic activity with North Korea, why is China still willing to provide aid to North Korea? There are three, more strategic, reasons why this might be the case.

First, if China would decide to cease or restrain exports to North Korea, containing vital goods, such as medicaments, fuel and food, this would certainly spark a humanitarian crisis. In fact, Chinese aid has become even more imminent, as several North Korean regions have been hit by serious spells of dry weather damaging crop production and leading to local food insecurities (see UN, 2017). Food shortages could potentially lead to a refugee crisis, something China will want to keep out of its borders. Moreover, it could potentially provoke a furious response from Pyongyang.

Second, North Korea’s position is geographically and strategically of vital importance to China. Hence, the maximum pressure it can extend on Pyongyang economically is limited by the fact that it cannot cause enough pain to bring down the regime.

Third, North Korea is sitting on a treasure of natural resources, including gold ore, tungsten, magnetite, zinc, copper and anthracite. Moreover, North Korea is believed to have a large amount of rare-earth metals, which are used in high-performance optical and electronic equipment, such as lasers, magnets and superconductors. Estimates of the total worth of these commodities vary between USD 2,000bn and 10,000bn. The problem is that North Korea is hardly capable of exploiting its own earthly valuables. This is where China can step in, by providing the technology and capital to exploit natural resources on a larger scale, and at the same time get a piece of the pie and safeguard the supply of scarce rare-earth metals.

What to expect?

It’s hard to predict the future at this point in time. After Trump’s fire and fury comments, North Korea announced that their military would set up a plan to fire four intermediate range ballistic missiles in the direction of Guam, but North Korean leader Kim Jong Un concluded that he “will watch a little more the foolish and stupid conduct” before deciding to launch missiles to the Pacific island. As such, immediate tensions turning into an outright nuclear war appeared to have subsided, but the recent exchange of angry rhetoric between both parties will put more pressure on diplomacy to ease tensions going forward.

A number of events in the near future will have to be closely monitored in the current crisis. Joint military exercises between the US and South Korea scheduled for 21 August could raise tensions, as North Korea strongly opposes these exercises. Furthermore, North Korea often marks national anniversaries for conducting nuclear and missile tests. On 25 August, North Korea celebrates the Day of Songun and on 9 September the Day of the Foundation of the Republic. If Korea decides to withhold from conducting tests on these anniversaries, this could be regarded as a North Korean sign of de-escalation. All in all, we expect tensions to remain over the near term, while an outright war is regarded as highly implausible, as there is simply too much at stake. But there is always a risk of miscalculation, given the unpredictability of the leaders in both the US and North Korea.

Meanwhile, China is still regarded to have the key for reaching a diplomatic solution. But under a scenario of lower diplomatic effectiveness, the likelihood of a continuation of the status quo is growing. As a result, it is more likely that targeted measures and sanctions will follow. Recent research by think-tank C4ADS shows that a small minority of Chinese businesses, around 5,200, traded with North Korea in the period 2013-2016, indicating that targeted actions towards these small companies could be effective. The research also suggests that North Korea’s sources to raise funds, a so-called ‘invisible complex overseas financing and procurement system’ could be targeted more specifically, leading to more effective implementation of sanctions. As such, pressure towards the North Korean regime will again be centered around its pressure point: its economy.

Share:
Author(s)
Hugo Erken
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 52308
Björn Giesbergen
RaboResearch Global Economics & Markets Rabobank KEO
+31 (0)30 21 62562

naar boven