IA Forum: North Korea introduced market reform measures in 2002. Five years on, how has North Korea fared?

Bradley Babson: Well, I think it's a mixed story. There have been some significiantly positive developments as the market economy has expanded, and that's partly because of their policies to in effect monetize the economy, by allowing prices to play a more significant role in economic transactions and activity and legalising markets which they did in may of 2003. Those two things along with the exapanding economic relationship - particularily with China - on a more commercial basis not government to government aid but really more transactions with Korea across the border, enterprise to enterprise, consumer goods coming in to North Korea from China, informal as well as offical trade growing: all of these things have tended to reinforce the marketisation process within North Korea, even it is still very small. That has been, in my view, a positive development which I would say was accelerated by their 2002 reforms process. Things had started earleir than that but they weren't really legal, and the farmers markets have really migrated into a different scale of market, it's now legal for enterprises to be trading in the market for intermediate goods and things like that so I think that all of that is a positive.

The negative side is they unleashed inflationary forces that they really didn't have the tools to manage. They don't have a very well developed financial system or macroeconomic policy capability so when they monetized the economy all of a sudden, they don't really have the instruments to steer the ship. That led them into some negative consequences which, through the erosion of purchasing power, has also led to some new, really vulenerable groups within the society whose needs were not being met through this mixture of market and state mechanisms, particularily in the urban areas. Of course on their side the State was losing control over things and not able to guide the population as directly as it had in the past, so from their point of view there were some negatives as well as positives.

A year or so ago they were doing some internal reflections on what they'd learnt from that and around January/February of 2006 they were travelling to China trying to learn from the Chinese experience and you got a sense that they were gearing up for -what we hoped would be- a new level wave of reforms. They didn't do it: the reformers about a year ago were put on the back bench, they've retreated, and that's when they started pulling out the missiles. In July they did the missile test, and in October the nuclear test and it seems that sometime around last April they put the economic reform agenda in the freezer and went forward on the military side.


IA Forum: Why do you think that is?

Babson: Well, I'm not sure. I mean there's a lot of reading of the tea leaves about what triggered the shift in approach, and I think it has something to do with the process of their negotiations in the 6 party framework and their perception of what the U.S. would and wouldn't deliver. I think the Banco Delta Asia issue was a factor behind the scenes, because I think sometime last winter they kind of woke up to the fact that this was actually a real problem for them, being denied access to the international financial system. It was a real bone in their side, they didn't see a way out of it very easily, and that may have influenced the internal political dynamic somewhat.


IA Forum: That's a question I wanted to ask you actually: How significantly do you think the Banco Delta Asia fiasco will put off foreign investors from dealing with the North Korean govt?

Babason: Well I would distinguish between the attitude of the investors which is always going to be very significantly influenced by their perception of risk, and North Korea was not a very good environment from a risk point of view even before Banco Delta Asia. So I'm not sure it'll have a huge effect one way or the other from an investor point of view. It certainly won't help them but it was a pretty bad investor environment to begin with.

The real problem is on their side. They have trading companies and other groups that are trying to do business with the rest of the world as North Korean firms. Some of them were accused of money laundering and doing bad things, but others were more-or-less engaged in normal commercial trade transactions. To some extent the consequence of the whole Banco Delta Asia experience has been to deny North Korean companies from access to the international banking system for normal trade and normal international financial transactions, and it was that systemic loss -not just the amount of 25 million dollars- which was really I think what hurt them most. I don't think that the resolution we've seen this last week of transferring the money with the Federal Reserve Bank as the correspondent bank for this transaction as a one-off is really going to solve that problem for them. They may have gotten their money back, or they may be about to get their money back, but I don't think that they have regained their access to the financial system in any significant way.


IA Forum: If I could move on to the fate of KEDO: What lessons do you think should be learnt from the failure of KEDO?

Babson: Well first thing, I'll point you to a report that's just come out on the lessons from KEDO which is quite good, published by the Stanley foundation [http://www.stanleyfoundation.org/publications/pdb/KEDO07pdb.pdf]. They've funded a project where some of the KEDO principals led by Charles Kartman and Joel Wit over the last year have conducted an evalutaion of the KEDO experience, and drawn lessons from it. A summary of that work has just been published as a policy brief by the Stanley Foundation. I think that document is a very systematic assessment of different dimensions of the KEDO experience and what is worth taking away, from I would say a group of people who are sympathetic to the value of KEDO and not critics of it.

My own view is that KEDO was a very interesting mechansim for engaging North Korea in a period when there weren't very many ways to do that, and that there were a lot of lessons from having a mechanism where people from outside could work together with North Korea on practical things, like digging holes, building things and actually trying to actually accomplish something physical. There were also a lot of useful lessons in how you actually work with North Koreans, including the micro-operational experiences of KEDO and KETCO (the South Korean power company), which are not really out in the public domain very much because they're really more within the technical relationship between the people who work together. But I think there were a lot of things that happened during the life of KEDO in North Korea: doing things on the ground, which have value in terms of longer-term thinking about economic development of North Korea, and people actually are going to work in partnership with them, and not in opposition to them. These positive lessons are something worth mining, and I think there's some of that that will come out of this report I mentioned to you. I do think a big lesson of KEDO, that's a message I've been preaching for a number of years, is that if you're going to choose an economic instrument to achieve a political objective, which is what they did when they said they'd build two nuclear reactors as part of the bargain for containing and then hopefully later reducing the plutonium nuclear program capabilities, the problem is if that economic instrument does not have its own intrinsic economic and commercial logic, sooner or later that lack of economic fundamentals will undermine the sustainability of the political achievement.

I guess my position has been that KEDO was not fundamentally economic: these Light Water Reactors (LWRs) were not an economic proposition and they weren't ever intended to be, by either the North Koreans or by the rest of us. Even though I think it's fair to say that Bob Gallucci and others raised the option of doing something more sensible on the energy needs of North Korea when they negotiated, the North Koreans weren't interested. They wanted LWRs. They wanted the relationship that would come with the joint effort and they really didn't see this as a solution to their energy problem in any practical way, and the project was not designed to do that. There's been a lot of stories about problems with the grid, the nuclear power takes power - if you don't have a grid that can sustain that, you can't ever actually use the power and if you don't have a stable environment... There is no transmission line in the project to connect the site to the grid anyway, nobody had ever talked about ongoing operation and maintenance and what kind of pricing policy for power would allow this thing to be sustainable, i.e. all the things that you would normally expect to see in a normal energy or power sector project.

A lot of the pieces of the puzzle were not part of the deal, which basically meant it was an uneconomic proposition from day one. Even technically it would not have worked, so sooner or later it would have undermined the nuclear negotiation objectives just in the way it was constructed. I think the lesson in that for the current six party talks is if you're going to be talking about economic incentives to go along with denuclearisation objectives, you want to design economic incentives so that they make sense; that they have an economic and intrinsic value that will stand on its own feet.

The other lesson is the problem with economic things is often they involve commited contracts, so if you have a mobilisation of a contractor to build something and he has working capital loans, and he has payrolls to meet, and then all of a sudden for political reasons you say "well we've gotten to an impasse and we need to stop things for a while," that creates a real distress for the contractor. And the on-and-off approach that we've seen constantly in the six party talks doesn't go well when you're actually doing a construction project where you've got timetables and costs: you just can't turn things on-and-off that easily. So if you're going to use an economic tool to sort of gerrymander a process of political agreements down the road, there's a very awkward character to it that you have to work with when you're asking people to commit real resources and pay real prices for things.


IA Forum: What is your perspective, then, on the proposals to run a pipeline from the Russian Far East to South Korea as part of a regional security building measure?

Babson: I think the test of that, is whether you can find a way to do it largely with commercial money and not with political aid, if it's viable from a commercial point of view meaning that most of the gas is destined for the South Korean market on commercial terms. Normally pipelines are not financed by governments, they're financed by private sources because the economics of it and commercial value justifies commercial investment. What governments need to do is create a legal and secured environment that reduces perceptions of risk, and that means getting political agreements and legal frameworks in place that will allow the private sector to do cross-boundary projects, and if you have more than one country involved then you have to have trans-national political and legal frameworks in place. The governments essentially guarantee to enable the private sector to do cross-boundary types of investments. That's kind of what Europe did when they did the Common Agreement on Steel and the foundation for the modern European Union: they used common interest in cross-border infrastructure and investment as a glue to get everybody to work together.

The question is: could you use a strategy like that in North-East Asia, that would both help solve part of the North Korean problem but also create an incentive for countries to want to work together, cooperate because of mutual benefits on energy. And that's where the pipeline has its kind of glamorous appeal, that there's a possibility it might contribute to creating a different *kind* of environment in North-East Asia that would reduce risks from a political security point of view and augment the possibility of sustained long-term economic cooperation.

Now, the wrinkle on North Korea is if a pipeline was to go across North Korea or offshore within its territorial limits, then North Korea could be given a fee for the transmission of gas across its territory, even if the financing was being done by private interests. If they had a fee that would give them some income, and if the gas is physically close then they could take some of the gas for their own purposes and have income to help pay for it, it would be a little formula that might help both their energy solutions in a certainly more environmentally friendly way than coal and politically less risky than nuclear might be and in a way that would give them a commitment to making this work because they have a benefit from it in the same way that Russia and South Korea would benefit from it on a commercial basis. And you get a little win-win-win, by creating an environment where that kind of action might be faesible: Japan might feel a bit better if they were having less environmentally damaging pollution in the Korean peninsula, which might give the Japanese something with which they'd be able to be good to North Korea about, and if you give this as an alternative to nuclear then it takes nuclear risks lower for the long term and everyone would feel better about *that*.

So there are a whole combination of reasons why I have felt for a while that this is an idea at least worth exploring. If it could be done with a commercial test then it would be really more likely to succeed in the long run. I worry with KEDO's background that if governments do it then they will not get the financial and economic incentives properly worked out and it would then be vulnerable later on.


IA Forum: Thank you very much. I have one more question. Taking a step back and looking a little more generally, what do you believe the development priorities should currently be for North Korea?

Babson: Well, that's a tough question, it depends on the strategy they're trying to pursue. I think - this is a personal view, because I think if you ask six different people who study the North Korea economy you wouldn't necessarily get the same answers. But I feel that one of the things that they really need to give priority to is building up their financial system capabilities. They do not have the institutions to manage either mobilisation of domestic resources through private savings or through public savings to generate the domestic resources for investment and development. The tools to do that in the banking system and in public finance are very rudimentary in NK, and ultimately if you're going to get a sustained economic development process they're going to have to find a way to mobilise domestic savings and make it work, as well as attract foreign savings and make sure those resources are being used in genuinely economically useful ways and not wasted on things that don't really produce value for them. So I think managing money and the tools, the policies, the instruments - the whole institutional capacity - is really critical. They probably have the least developed financial system of any country I know of in the world, because they weren't even monetized until 2002. It wasn't even ever an idea of how they were going to do things, they were very driven by state managed distribution systems. As the market processes begin to take root, then modernisation markets and financial systems need to be developed. To me that's a critical gap and they're way behind the curve on the financial systems side.

Now that's an institutional and policy response to your question, but if you were to say "well, here's some money, what shall we give priority to?", I guess my answer is I would certainly try to do things to stimulate further development of the markets as resource allocation mechanisms. There's a huge amount of inefficiency within their resource allocation and framework that they've built up, so helping the markets play the role that markets can play is probably going to do more for the larger base of the Korean population than lumpy kinds of things that governments do. That's not to say you shouldn't be doing things with infrastructure, energy, transport, to help remove infrastructure bottlenecks. But you really want to stimulate small scale commercial activity.

I think that with China and South Korea right next door, finding ways to expand trade and investment relations with the neighbouring countries is a good thing and that's already started. So you can see Kaesong expanding, you can see Chinese investment relationship expanding. If they were able to normalise relations with Japan, regain access to Japanese markets and get some Japanese investment going that would also be good for them in terms of getting regional markets for the stuff that they can produce. Those are the areas I would give priority to.
Of course they want to focus on agriculture and try to do what they can on the food side, but the reality is they've got to start expanding their trade oriented economic growth strategy because they're going to have to become more outward orientated if they're going to get sustainable growth. So things that will help them do that from my point of view will be pretty high priority.

IA Forum: Bradley Babson, thank you very much.

Bradley Babson is a consultant on Asian Affairs, concentrating on North Korea and Northeast Asia economic cooperation, and worked for the World Bank for 26 years. He has participated in projects on North Korea sponsored by the Center for Strategic International Studies, the U.S. Institute for Peace, the National Bureau for Asian Reseach and the Stanley Foundation. From 1997 until 2000 he was a senior advisor to the World Bank’s Regional Vice President for East Asia and the Pacific, and before that was the World Bank’s first Resident Representative to Hanoi.

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