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Whither the Kaesong Industrial Complex?

21 May 2013

Kim Dae-jung’s Sunshine Policy was a bold experiment that sought to achieve unification by decreasing inter-Korean tensions and establishing a cooperative framework of engagement. To accomplish this, the policy promoted the restoration of road and rail links and economic assistance projects that included aid and inter-Korean business ventures in mining, agriculture, tourism and textile production. The crowning achievement of this policy was the Kaesong Industrial Complex (KIC), an industrial park in the North Korean city of Kaesong which combined North Korean labor and South Korean capital to produce consumer goods for global markets. By 2012, the KIC was composed of 123 companies that collectively employed 53,448 North Koreans and generated $470 million in sales.

Unlike every other project launched under the Sunshine Policy, the KIC weathered the ups and downs of inter-Korean relations, and until recently, it appeared to be a durable project sustained by strong political support on both sides of the DMZ. However as tensions rose this year following the DPRK’s rocket launches in April and December 2012, its third nuclear test in February 2013, the issuance of UN Security Council Resolutions 2087 and 2094 and the conduct of joint US-ROK Foal Eagle exercises, the KIC was drawn into a cycle of escalating retaliatory measures. Running out of non-military chips to play, on April 9, 2013, the DPRK ordered KIC employees not to report to work. Operations in the complex ground to a halt. After the DPRK rejected talks with the ROK on April 26, the South Korean government ordered its citizens to leave the KIC. On May 3, the last South Korean left the KIC after settling accounts for back wages and income taxes owed to the DPRK. As of this writing, it is unclear whether the KIC will ever resume operations.

In retrospect, we can see that the goals policymakers sought to achieve through the KIC were unrealistically ambitious given the constraints under which the enterprise was required to operate.

To begin with, Kaesong’s infrastructure was unable to support a large industrial park. The South Korean government had to underwrite the construction of new roads, water treatment centers, housing, hospitals, gasoline stations, a fire department, customs offices and more. The cost of this investment has reportedly totaled 900 billion won (802 million USD). Although these costs were not born by the companies in the zone themselves, they were born by the South Korean government and must be considered when assessing the success of the venture.

Second, KIC’s production possibilities were limited from the beginning. South Korea is a signatory to the Wassenaar Arrangement, an international treaty that prevents state parties from exporting technology to the KIC that could potentially be used for military purposes. Though Wassenaar did not directly affect the textile firms operating in the KIC, it did preclude the development of the high-tech manufacturing base that the North sought to acquire from the South. Under this agreement, it is highly unlikely that workers in the Kaesong zone would ever have received the required technological capital which would allow them to develop the skills to produce higher-valued outputs.

Third, managerial control of firms was restricted. Firms in the KIC operated under numerous rules that hindered the development of workplace efficiencies as well as the flow of information between North and South Koreans. Unlike typical managers, South Koreans in the KIC lacked the flexibility to select workers and their interactions with North Korean employees were fairly restricted. In fact, North and South Koreans were forbidden from even eating together or socializing after work. Firms interested in hiring North Korean workers were required to submit the number of employees they desired to the KIC Management Committee (under the North Korean government) and the workers would be assigned to them. Firms had little opportunity to recruit and select the best candidates for a position directly. Although firms in the KIC were required to offer a five percent annual wage increase irrespective of workforce productivity gains, this rule was effectively suspended from 2003 until 2007, likely as a result of the time required to raise workforce skills to a level where they could produce goods of sufficient quality to sell to foreign consumers.

Moreover, bureaucracy and security were a burden for managers. Since the DPRK could not allow workers in the KIC to engage in unauthorized communications or be exposed to unauthorized information, South Koreans were prevented from bringing print media and mobile phones into the KIC. The internet was also prohibited. Managers had to stay in touch with their offices in the South via landline. Additionally, the DPRK never streamlined entry requirements, so individuals who regularly visited the complex were required to go through a full clearance on each visit.

KIC products also had limited access to global markets. Though some goods produced in the KIC were given preferential tariffs among ASEAN countries, they were excluded from free trade agreements made with the United States and the European Union. KIC goods were thus subject to tariff levels that made their importation uneconomical and the majority of sales were limited to the South Korean market.

Finally, KIC firms faced restricted access to capital. Ex ante, firms setting up in the KIC could reasonably predict risk from unexpected/coerced contract renegotiations and/or expropriation of assets. This made capital intensive investments too risky for most financial institutions. To resolve this problem, the South Korean government supported low-interest loans to provide bridge capital during liquidity crunches and to fund capital improvements that commercial banks believed too risky. South Korea also offered political risk insurance to compensate business owners that were forced to close or whose assets were seized.

But these subsidies, while making investment in the zone possible in the first place, may have also deterred the DPRK from developing credible, responsible policies that would have nurtured the development of the KIC. How? Although firms in the KIC were struggling build profitable businesses, the DPRK never seemed satisfied with the level of revenue from wages, taxes and user fees it was receiving. Firm profits were far from exuberant, yet costs were designed to climb. In a situation where firms did not have access to South Korean subsidies, the North Korean government would have to negotiate the level of taxation it was going to levy if it wanted the firms to remain in business. Since firms in Kaesong were subsidized, however, the DPRK had no interest in developing accommodating policies for KIC firms. It could push to raise costs in the KIC and the South Korean government could intervene to keep businesses afloat. Perhaps this is the rational, budget-maximizing position, but it is not the responsible one. Had the DPRK adopted credible and responsible policies from the beginning, we would have seen the need for South Korean government subsidies decline over the years and a general increase in confidence that contract and property rights would be protected.

Though the KIC appears to have failed at both moderating crises in inter-Korean relations and promoting economic reform in the DPRK, it did bridge the information divide separating the Koreas through what I refer to as the “Choco Pie effect.” Choco Pies are South Korean snacks made up of two small round layers of cake with marshmallow filling and coated in chocolate. KIC managers would routinely give these to their North Korean employees who would take them home and sell them in local markets. Over time, working conditions in the KIC became associated with these treats. The popularity of Choco Pies reminded North Koreans in distant parts of the nation that the jobs in the KIC were among the best in the country. Wages were higher, managers more effective and workplace amenities such as heating, air conditioning, medical care and dining facilities were incomparably better than other workplaces in the DPRK. This fact radically undermined the DPRK’s official propaganda narratives that described South Koreans as repressed, poor and exploited brothers who longed to be united with their countrymen in the loving embrace of the Kim family.

So what lies ahead? In the short-run the South Korean government will be required to bail out the firms that invested in the KIC. As of this writing, losses are estimated to fall between one and three trillion won (900 million—2.7 billion USD). Seoul will also need to make a determination on the flow of electricity to the KIC, which is transmitted from a substation in South Korea. The voltage has a capacity of 100,000 kw but has been reduced to 3,000 kw to maintain a treatment facility that provides clean drinking water to the city of Kaesong.

In the medium-term, the two Koreas will need to decide if they wish to reopen the KIC. If rumors are to be believed, the DPRK reassigned all 53,000 workers to other state owned enterprises within days of the KIC’s closing. This would imply that plans to close the KIC had been in the works for some time. It would also imply that the DPRK leadership views the KIC as a domestic political cost not worth the fiscal benefit. If the DPRK closed the KIC merely as a tactic to win additional concessions from the South, however, then it may be possible for the project to resume after some protracted face-saving negotiations.

From the South Korean perspective, policymakers must decide if the political and economic benefits are worth the fiscal costs of supporting the KIC. We can now say definitively that no investment in the KIC will be immune to the ups and downs of inter-Korean political tensions in the future. This will raise the cost of subsidies required to encourage firms to invest in the KIC. Additionally, the firms most interested in investing in the KIC have been badly burned. Their experience will deter other investors from investing in the KIC until credible, substantive changes to the KIC’s governance structure are made.

Reader Feedback

7 Responses to “Whither the Kaesong Industrial Complex?”

  1. […] failure and resumption of the Kaesong Industrial Complex last summer imposed high financial and political costs on both sides. But the outcome of negotiations to revive the project reveals that inter-Korean progress comes not […]

  2. […] failure and resumption of the Kaesong Industrial Complex last summer imposed high financial and political costs on both sides. But the outcome of negotiations to revive the project reveals that inter-Korean progress comes not […]

  3. SMH says:

    Eighty percent of profits went to South .Only twenty percent went to North . What ever happened to equality? A fifty fifty split of profits would have been more reasonable . When work with capitalist how much profit is left? Another rip off by West .Always what western business sells is hyped up but final product does not live up to expectations. But engagement and dialog is better than isolation.

  4. Tim Who's New to NK Politics says:

    I’m relatively new to NK politics but have followed it close enough recently to follow this article and it appears that Kim Jong-Un is becoming increasingly paranoid about outside influence: tightening security at the Chinese border, consolidation of his power, his belief that the US-ROK were planning an invasion (though that could very well be rhetoric to keep his people “in line”) and finally shutting down Kaesong, one of the few hard currency drivers for the DPRK. It will be interesting, though, to see if the new policy allowing farmers to keep the excess grain to barter, sell, keep, etc. will work.

    R…I agree that Curtis should have called out that the FTA didn’t come into effect last year but keep in mind the US has had a near total embargo on imports from North Korea. Also, I believe there is an annex to the KORUS FTA that requires a committee to approve the trade of items made in Kaesong but don’t quote me on that.

  5. Jake in South Korea says:

    First half of the article was new information for me so I can’t really say if I agree or disagree with it. But from the 11th paragraph on I’m going to have to say I agree. Everything that the DPRK gov’t has done in the last year or two has really been aimed at consolidating control over it’s populace. Increasing security on it’s Chinese border to stop defectors from exiting North Korea and to decrease smuggling and outside influence (TVs, illegal radios, DVDs, ect.) from entering North Korea. Closing down the KIC for the very reason that was stated in this article. Manufacturing a crisis by launching the missile and testing the nuke as well as putting the country into a stated of lock down by requiring people to take shelter in underground complexes, all to scare the people into submission. The DPRK gov’t started all of these because it felt that it was losing it’s grasp on the North Korean people.

    As for the South Korean side, the ROK gov’t has already said that they won’t allow the DPRK to have talks with with the companies from the KIC until the DPRK gov’t held working-level talks with the ROK gov’t (presumably to keep the DPRK from undercutting the ROK gov’ts authority). And considering the current state of relations between the two gov’ts, that’s probably not going to happen for a while.

    And even if they got the KIC back up and running again it would be less productive than it once was (or even less productive than it already was, taking into account the information of this article), because the companies will be wary of putting too much investment into it, on the chance that the KIC could be closed again with no prior warning. It might just be best for South Korea to cut it’s losses and give up on the KIC. Until we see North Korea get it’s act together and get it’s economy up and running (cough) it’s unlikely that we’ll see any effective inter-Korean exchanges.

  6. r says:

    The USA ROK free trade agreement only went into affect last year and the EU ROK agreement the year before that , Kaesong has been running for 10 years . Curtis Melvin makes it sound like this was a factor affecting buisness ( deliberately so I am sure ) How can that be when they were operating for 9 years before any FTA ?
    If SK buisness was not profiting they would not be there , that is clear.
    Curtis you lose credibility for the rest of the article when you deliberately mislead readers.

  7. Matt in Sunshine filled KY says:

    Oooo…it pains me to see so much truth like that. This part has been garbage the whole time. I heard it called an intelligent strategy for protecting the Juche ideology…garbage. I’m anti greed and still think this is a tasteless move. So the South Koreans went way out of there way to improve relations and quality of life–for all Koreans–and DPRK stiffed them and left them with the bill? If I was KJU I’d be working on getting that spot back open and lifting those trade restrictions–by getting off those nukes keeping themselves hostage. That’s just me. I already knew that the unarmed minuteman wasn’t aimed at anyone–because I’m not hiding behind a propaganda blanket. Wake up, KJU!

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Credit for photo of young North Korean girl: T.M. All rights reserved, used with permission.