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Same-Day Analysis

North Korea's special economic zones not conducive for investment despite reforms

Published: 08 January 2015

North Korea designated 20 new special economic zones in 2013 and 2014.



IHS perspective

 

Significance

Despite North Korean leader Kim Jong-un's emphasis on economic development and the latest drive to establish special economic zones (SEZs), the country still lacks the judicial framework and infrastructure for the SEZs to gain traction.

Implications

The SEZs will not lead to large-scale changes in the North Korean economy, and risks remain too high for long-term, sustainable investments to be conducive.

Outlook

North Korea's emphasis on nuclear weapons development, as well as the government's opaque nature, will persist for the foreseeable future, leaving its economic environment too risky for sustainable investments.

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Coal-transporting cranes in the port of Rajin in the urban area of Rason, North Korea.
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North Korean leader Kim Jong-un in his New Year's address on 1 January 2015 reiterated the dual policy line of nuclear weapons development and economic progress that his administration adopted in April 2013. Although North Korea's diplomatic belligerence has continued under Kim, he has placed more focus than his predecessor on economic reform and progress. One of the most important economic policy implications of this strategy thus far has been the creation of 20 new special economic zones (SEZs) between October 2013 and July 2014.

The recent SEZ drive has led to a number of significant policy changes, such as the introduction of legal reforms pertaining to foreign investor's rights and increased autonomy for localities to develop SEZs (outlined below). Nevertheless, crucial obstacles will continue to prevent the zones from taking off. These obstacles include the high risk of contract alteration and expropriation without effective legal recourse, North Korea's at times volatile foreign policy, and its opaque and unpredictable governance system.

Although the government has experimented with SEZs in the past, the recent drive is by far the most ambitious to date. North Korea is heavily dependent on raw material exports, and as world market prices have fallen, the regime's need for more sustainable sources of economic revenue has become increasingly urgent.

The zones mainly span five areas: export processing, industry, agriculture, tourism, and an ambiguously termed "economic development" category. Emphasising the government's ambitions, the state-run Korean Central News Agency (KCNA) quoted a government official on 12 November 2014 stating that "economic development zones" will be set up in "every province and municipality".

North Korea has been experimenting with SEZs since the mid-1980s. However, except for the Kaesong Industrial Region, which is financially and politically backed by the South Korean government, and a zone in Rason in the northeast of North Korea, which has had moderate infrastructure investments by Russia and China, none of the SEZs have managed to attract sustainable investments. South Korean daily Chosun Ilbo reported on 20 December 2014 that none of the new zones had attracted any foreign investments to date.

Greater administrative autonomy for local governments likely to produce positive change

One of the most important changes concerns administrative autonomy and incentives for local governments to establish SEZs. Foreign companies and local authorities can now appeal to the government to create new zones, and planning and implementation are largely left to the local level. The increased local autonomy may lead to provinces competing among each other to create the most favourable conditions for investment, and creates room for local experimentation with investment rules and governance.

Andray Abrahamian, Executive Director of Choson Exchange, a Singapore-based non-governmental organisation that runs training programmes on economics and business in North Korea, said in an interview with IHS on 2 January 2015 that this room for economic experimentation is one of the most promising aspects of the SEZ reforms, as it allows North Korea to incrementally change rules that make investment difficult, such as the lack of communications (such as internet access) and rules for hiring. For example, the zone in Rason has been able to circumvent the strict visa rules that normally apply to foreigners and can now issue local travel permits within 48 hours. However, the central government is still able to override and limit local rules that it sees as threatening to its authority or otherwise problematic, and it retains the authority to expropriate property and arbitrarily change the terms of investments.

Laws regarding investment have also been revised to create a more accommodating environment, but the language of these laws remains ambiguous. The law that supposedly guarantees protection from government expropriation makes an exception for "unavoidable circumstances" and states that "sufficient compensation" shall be given in such occurrences. Other articles state that "legitimate" profits can be remitted from the zones. Since North Korea lacks an independent judiciary, investors will continue to face the risk of arbitrary decisions by the state.

The temporary closure of the Kaesong Industrial Region in 2013 showed that the regime is prepared to break or reinterpret economic agreements as a result of political tensions. Following the closure of the zone, South Korea warned the North against the confiscation of the assets of South Korean companies. The fact that such a warning was made highlights the reality that North Korea has used expropriation and the threat of expropriation as a way of putting political pressure on South Korea in the past and could do so again.

Outlook and implications

The institutional environment for investments may well become more favourable through local competition and regime initiatives, particularly since world market prices on raw materials are projected to continue to fall throughout 2015. Some zones, especially those designated for tourism, and those that have the strong backing of individuals within the government bureaucracy, may manage to become operational and raise some hard-currency revenue.

However, the core obstacles for sustainable and safe investments will remain. Neither North Korea nor its neighbours seem to be willing to make the large-scale infrastructure updates that are needed for the SEZs to function smoothly. William Newcomb, a visiting scholar at the US-Korea Institute at the Paul H. Nitze School of Advanced International Studies (SAIS) at Johns Hopkins University, projected in an interview with IHS on 18 December 2014 that the SEZs would at best attract short-term, labour-intensive, low-tech investments from businesses with models suitable for high-risk environments. Although literacy rates are high, labour-force skills remain relatively low. While such investments would raise the short-term revenue, they will not lead to a systemic and transformational change of the sort that China's SEZs once contributed to.

The politically volatile nature of the government shows no signs of changing in the foreseeable future. As long as North Korea continues its emphasis on nuclear weapons development – enshrined in its constitution – relations with neighbouring countries and the United States will remain hostile, leaving economic sanctions and geopolitical volatility in place. In late 2014–early 2015, leaders of North and South Korea proposed to hold talks between the countries, but it is still unclear whether such negotiations will occur. Even if they do, it is unlikely that they would lead to any pledges from the North Korean regime to scale down its development of nuclear weapons, leaving geopolitical conditions too volatile for sustainable investment conditions.

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