KOREA FOCUS
Kaesong Industrial Complex as Key to Peace on Korean Peninsula
Yang Moon-soo

Professor
University of North Korean Studies


I. Introduction

 

The Kaesong (Gaeseong) Industrial Complex, the pilot economic cooperation project between South and North Korea, is in a state of “temporary closure.” This marks the complete suspension of inter-Korean economic cooperation projects, which began with the so-called July 7 Declaration in 1988. It follows restrictive steps by the North, starting with barred entry of South Korean managers and materials into the complex and ending with the withdrawal of all North Korean workers from the special zone. Thus, nine years after South Korean manufacturers began operations in Kaesong across the border, the joint industrial complex is empty.

 

After the conservative Lee Myung-bak administration took over in 2008 and adopted a hard-line approach toward Pyongyang, provocations and reactions raised doubt about the fate of the complex. In July 2008, the Mount Kumgang (Geumgang) tourism project was suspended after North Korean guards fatally shot a South Korean tourist. Two years later, after the sinking of a South Korean Navy patrol craft in the West Sea, the South suspended merchandise exchanges and bonded processing. Nevertheless, the industrial park remained open until recently.

 

This study examines the history and significance of the complex and its future prospects as part of the debate over strategies for restoring peace on the Korean peninsula. The final section explores policy tasks for the South Korean side.

 

II. Background and History of Kaesong Industrial Complex

 

1. Background and Initial Blueprints

 

The Kaesong Industrial Complex developed from the West Sea Industrial Development Plan that the late Chung Ju-yung, head of the Hyundai conglomerate, proposed during his visits to Pyongyang in December 1998 and February 1999. Chung envisaged a complex covering about 6,500 acres on the west coast of North Korea, which Pyongyang authorities generally accepted.

 

Hyundai Group initially suggested Haeju, a port city near the South-North border, but North Korean leader Kim Jong-il preferred Sinuiju, near the Chinese border. After the June 2000 summit between South Korean President Kim Dae-jung and the North’s Kim Jong-il, relations between the two Koreas rapidly improved. The two sides eventually agreed on the construction of a large-scale industrial estate near Kaesong, about 16 km north of the border separating the two Koreas. 

 

At the outset, the Kaesong project envisaged an industrial zone and residential town covering 66 square kilometers in Kaesong City and Panmun County of North Korea and South Korean enterprises operating manufacturing facilities and North Koreans manning assembly lines. South Korean developers were to secure 50-year land leases along with other business rights from North Korean authorities and distribute parcels to South Korean and international investors.

 

The project zone of the complex, situated 160 km from Pyongyang and 70 km from Seoul, is to consist of 6,400 acres of industrial plants and 9,600 acres of residential town. The industrial section is to be developed in three stages: 800 acres in the first stage, 1,200 acres in the second and 2,800 acres in the third stages. (After the initial agreement, the second and third stages were revised downward from 1,600 acres and 4,000 acres, respectively.)

 

Upon completion of all three stages, a total of 2,000 firms are to be operating in the complex, employing as many as 350,000 North Koreans and producing US$16 billion worth of manufactured goods annually. The master plan called for labor-intensive small manufacturers in the first stage, followed by export industries linked to the financial market of Seoul and logistics systems based in Incheon, South Korea, which has large air and sea transportation facilities. The third stage is expected to feature heavy-chemical and high-tech industries, including multinational businesses, making Kaesong an economic hub in Northeast Asia.

 

The project was seen as a great opportunity for win-win cooperation with the promise of huge financial returns after the three stages are completed: 24.4 trillion won ($21 billion) in total value added and 104,000 work positions for South Korea, and $600 million income through 725,000 jobs for North Korea annually.

 

2. Bottlenecks and Twists in the Progress

 

The Kaesong project has faced numerous problems in the course of its implementation. In the early stage, financial difficulties at Hyundai Asan Corporation delayed the ground-breaking and the two Koreas haggled over investment conditions for South Korean businesses. The mercurial security situation on the Korean peninsula also has affected progress. For example, the North’s missile launches and its first nuclear test in 2006 led to the postponement of the distribution of plots for individual investors and a number of them withdrew from the project.

 

An even bigger problem erupted in the autumn of 2008 when the North began to pressure the Southern businesses for more financial rewards. In December 2008, the North drastically reduced the number of South Korean vehicles and personnel allowed into the complex. In March 2009, when South Korean and U.S. forces conducted their annual Key Resolve joint exercise, North Koreans blocked traffic between the complex and South Korea three times without prior notification, and they arbitrarily detained a Hyundai- Asan employee for several days, accusing him of making unfriendly remarks about the North.

 

Pyongyang upped the ante in the following months by unilaterally declaring a review of the wages for its workers and the rent for the distributed land. They abrogated regulations and contracts and unveiled new contracts. South Korean investors generally ignored the North’s action. However, purchase orders fell and suppliers were reluctant to send shipments, fearing payment problems. The North finally eased the pressure in August 2009.

 

After the North’s sinking of the Cheonan patrol craft and artillery shelling of Yeonpyeong Island in 2010, the South imposed economic sanctions, including a ban on new investments in the Kaesong complex. Pyongyang again mentioned the possibility of closing down the complex as inter-Korean relations plummeted.

 

3. Progress of the Project

 

The chronology of major events in the project include: the signing of a business agreement between Hyundai and North Korean authorities in August 2000; ground-breaking ceremonies in June 2003; land leveling work in April 2004; and release of the first products, “Kaesong kettles,” in December 2004. The leveling work was completed in 2006 and all basic infrastructure for power, water supply, communication and waste disposal was in place by October 2007, when ceremonies were held to mark the completion of the first stage project.

 

Plant sites were distributed to a total of 222 firms on three occasions between 2004 and 2007. Up to 300 firms are expected to be operating in the first stage project zone. When the complex was closed in May, there were 123 firms.

 

The number of enterprises has increased from 18 in 2005 to 123 in 2012, with the total number of North Korean workers rising from 6,013 to 53,448 and annual output soaring from $14.9 million to $469.5 million during the same period.


III. Significance of the Kaesong Industrial Complex Project

 

1. Economic Significance

 

To examine the significance of the Kaesong complex to South and North Korea, it is necessary to assess its accomplishments so far. The greatest achievement, of course, is that the complex has successfully established a win-win economic cooperation model. Throughout the 25 years of inter-Korean economic contacts, the complex was the first and only successful model of cooperation. With the first stage finished, the complex represents the possibility of establishing second and third industrial complexes in the form of special economic zones.

 

The basic concept of the project is for South and North Korea to combine their strongest elements of production ― capital and technology in the South and labor and land in the North ― to gain increased competitiveness in a win-win situation.

 

For the South Korean economy, Kaesong offers a new life to small industries that are struggling with rising wages and high rent and are unable to move production abroad, and also benefits enterprises that want to return production onto Korean soil after unsuccessful operations offshore. With these companies surviving by relocating to Kaesong, the South’s industrial competitiveness will rise and the seeds of new growth engines can be planted.

 

The Kaesong complex also built strong business links with home industries. A recent research report revealed that Kaesong manufacturers on average had supply contracts with 34.4 South Korean firms and transactions worth 4.79 billion won each in 2010. Between 2005 and 2010 (by September), the complex created industrial inducement effect for $4.74 billion, value added effect for $1.38 billion and employment of 19,721 workers.

 

As for North Korea, the project provides various resources that are necessary for its economic revival. It offers not only the wages for the burgeoning number of employees in the joint project but also foreign exchange income. The complex offers opportunities to learn advanced technologies and gain operational skills while helping the North gain an international image of economic openness.

 

If the project develops as planned, the overall scale of inter-Korean economic cooperation and exchanges will be expanded and a relaxation of tensions on the Korean peninsula can be expected. As a result, international credibility will go up for both the South and the North and help them attract foreign investment. Thus, the creation of a single economic community encompassing both parts of the divided peninsula may be expedited.

 

2. International Competitiveness

 

To understand the economic significance of the Kaesong complex, it is necessary to assess its international competitiveness. This study chose a special development area in Shandong Province, China, and industrial complexes near Hanoi and Ho Chi Minh City in Vietnam for comparison with Kaesong. The time frame is 2010 but some data are 2007-2009 figures.

 

First, land costs and taxes in the Kaesong complex are lower than those in China and Vietnam but plant construction costs are twice as high. It is because firms operating in Kaesong hire South Korean builders and use South Korean building materials.

 

The Kaesong complex also has a significant comparative advantage in logistics and customs, in addition to exemption of taxes, because of its proximity to South Korea. On the other hand, Kaesong manufacturers cannot procure raw materials from North Korea or sell their products in North Korea.

 

The wage scale in the Kaesong complex is lower than those of the Chinese and Vietnamese counterparts. The monthly pay in Kaesong is $60.80 whereas it is $111.80 to $135.50 in the special development zone in Shandong and $63 to $71 in the industrial complexes near Hanoi and Ho Chi Minh City. Including the basic salary, the total cost per worker is $129 in Kaesong, much lower than in China and Vietnam. The amount breaks down to $80 for salary and overtime, and $49 for meals, transportation, insurance and other benefits. The average worker’s cost stands at 28 to 35.1 percent of the average cost of $368 to $460 in Shandong Province and 78.7 to 85.4 percent of $151 to $164 in Vietnam.

 

As for productivity, survey results in the early days of the Kaesong complex are available. In most items, the firms were more productive compared to Korean businesses in China. North Korean workers’ labor productivity was 8 percentage points higher than their Chinese counterparts, perhaps because of Kaesong’s low employee turnover and the North Koreans’ strong work ethic. Manufacturing cost was 7 percentage points lower in the Kaesong complex, while product quality was 2 percentage points higher. Easy communication with the same language and application of the same production standards used in the sister unit in South Korea are believed to improve productivity in Kaesong. The average operation rate in Kaesong was 15 percentage points higher than the Korean-invested manufacturers in China. It was because relatively new facilities were moved into Kaesong and advanced management methods were adopted.

 

In other research, enterprises were asked to judge their North Korean workers’ productivity. Only 10 percent said they were dissatisfied while 33.8 percent were satisfied or very satisfied and 56.3 percent rated performance as average.

 

Overall, the Kaesong complex is inferior to the manufacturing areas in China and Vietnam in terms of plant construction costs, raw materials procurement and sale of products in the local market. On the other hand, Kaesong provides favorable conditions regarding land cost, logistics, wage scale and taxation. It should also be considered that the investment environment in China and Vietnam is rapidly deteriorating with steep rise in wages and other detrimental business conditions.

 

South Korean managers of manufacturers in the Kaesong complex generally believe that productivity there is good or average. Among respondents in a survey asking about competitiveness, 7.4 percent said “very high,” 54.4 percent just “high,” 33.3 percent “average,” 3.7 percent “low” and 1.2 percent assessed it “very low.”

 

3. Political and Social Significance

 

The Kaesong complex has as strong socio-political significance as its economic significance. First, it can contribute significantly to improving and developing inter-Korean relations. The construction and operation of the industrial complex lead to large-scale human contacts and exchanges, which can help reduce tension on the Korean peninsula. Increased economic dependence between the South and the North through the complex may also help stabilize relations between the two sides. Indeed, when inter-Korean ties have tightened, Kaesong has had a calming effect.

 

Since 2008, Pyongyang has occasionally threatened to close down the Kaesong complex but it has checked itself. It describes the current shutdown as “temporary” and claims to reserve the right to decide on an ultimate closure. Seoul, for its part, excluded Kaesong when it decided extensive economic sanctions against the North on May 24, 2010 for the torpedo attack in the West Sea. Both the North and the South feel a great political burden when they make any decisions on the Kaesong complex.

 

The May 24, 2010 measures were of special significance to the joint industrial complex. As South-North trade and other forms of contacts were entirely cut off in retaliation for the North’s military provocations that caused the loss of lives, Kaesong became the only opening between the two Koreas.

 

Second, the Kaesong complex is promoting reform and openness of North Korea. While carrying out the joint project, North Korea is learning the mechanisms of a market economy. North Korean officials involved in the administration of the complex, mid-level managers and workers are attentively watching how manufacturing plants function in a market economy system. The North Koreans are especially eager to learn about taxation, insurance and accounting systems of the capitalist world when negotiating payment arrangements with the South.

 

North Korea is acquiring know-how for external opening through Kaesong. Beyond simply offering land and labor for foreign investors, they are trying to improve investment conditions and work environments though their experiences in Kaesong. It is a valuable model for the North’s opening of other areas for external economic collaboration.

 

Third, Kaesong, which was originally a strategic point of military operations in the western part of the border, has turned into a place of peaceful economic cooperation, thereby helping reduce military tension in the area. When work started for the industrial complex, North Korean ground forces deployed there were moved out of the area. It had the effect of redrawing the Military Demarcation Line some 10 kilometers to the north. The Kaesong-Munsan corridor, a traditional invasion corridor from the North, now serves as the supply route for inter-Korean economic cooperation.

 

Fourth, the Kaesong complex has helped change North Korean people’s perceptions of South Korea. As working in the complex improves the livelihood of local residents through a high salary by North Korean standards and various welfare benefits, the employees and their neighbors have shed their enmity toward the South and turned into admirers of South Korean life.

 

4. Limitations and Problems

 

The Kaesong complex still has problems. The biggest issues are transportation, communication and customs clearance. The rigid procedures for entry and exit cause the biggest headaches. Telephone and facsimile can be used but Internet and mobile communication is not available.

 

The restriction on “strategic items” and the rules on the country of origin are major obstacles to the development of the joint industrial complex. South Korean firms face difficulties in installing production facilities in the complex because they should be inspected for possible use as strategic goods.

 

Kaesong products are labeled “Made in North Korea,” so the chances of exporting them is severely limited due to international sanctions prompted by North Korea’s nuclear and missile tests. Export of North Korean-made goods to the United States is not banned but is virtually impossible because of extremely high tariffs. The Japanese market is similarly inaccessible.  

 

Workforce supply is another problem. North Korea, unable to provide dormitories for the tens of thousands of workers at Kaesong, asks South Korea to build them. Seoul not only needs financial arrangements to build the additional facilities but also social consensus to do so.

 

The Kaesong complex has the fundamental problem of entirely depending on South Korean investment, which is different from special industrial zones in China or other countries. North Korea’s Kaesong Industrial District Management Committee has a scant source of income and weak budgetary independence. The complex is more like a large bonded processing park rather than a special economic zone. It has little connection with North Korean economy as raw materials are not supplied from the country and products are not sold there.

 

Lastly, it should be noted that the complex is vulnerable to tensions on the Korean peninsula. When North Korea’s missile launches and nuclear tests prompted international sanctions, the investment environment for the complex quickly deteriorated and so it did when the North staged military provocations against the South that led to Seoul’s own economic sanctions. Buyers withdrew and production declined on such occasions.

 

IV. Temporary Closure: Assessment and Prospects


1. Assessment

 

The primary reason for the “temporary closure” was the North’s abrupt restrictive measures and the South’s uncompromising response. North Korea without prior warning blocked the entry of South Korean personnel into the industrial complex on April 3 and then announced the withdrawal of all North Korean workers five days later. South Korea repeatedly asked for discussions to resolve problems (on April 8, April 11, and April 25), but the North ignored the requests. Seoul on April 26 decided to pull out all the Southern personnel from the complex and completed the withdrawal on May 3.

 

The North’s actions were extreme and self-destructive for any reason. It is understood that they were connected to the North’s increasingly provocative stance and the international community’s hard-line response. Pyongyang used Kaesong as a scapegoat to raise the tension on the peninsula and increase pressure on the United States and South Korea.

 

But the North’s steps clearly violated the 2003 agreement on four major economic cooperation projects and the 2005 accord on entering and staying in the Kaesong complex and the Mount Kumgang tourism area. Even North Korea’s domestic law on the Kaesong Industrial District enacted in 2002 stipulates that “investors’ rights and interests shall be protected.” As the international community watched, the North’s arbitrary action must have embarrassed potential investors in China and other foreign countries.

 

On the other hand, Seoul’s quick and decisive pullout of all Southern personnel invited mixed opinions. Supporters said that the South demonstrated its determination not to be manipulated by the North anymore and did what was needed to protect its people when the North barred food and medicine for those who remained in the complex.

 

Detractors said the pullout aggravated inter-Korean relations and shelved the “trust-building process” that President Park Geun-hye had pushed since her inauguration. Some were particularly critical about Seoul’s ultimatum of a “grave decision” issued on April 25, giving the North only one day to reply. In a National Assembly Foreign Relations and Unification Committee meeting, even some ruling party members expressed regret that the government acted too rigidly. It was pointed out that the Unification Ministry was unwise to make the move while a South Korea-U.S. military exercise was still in progress, a time Pyongyang usually stops speaking to Seoul. Besides, April 25 was a North Korean holiday.

 

2. Ripple Effect of Closure

 

An irrevocable shutdown of the Kaesong complex would deal a tremendous economic loss to both South and North Korea. According to the Unification Ministry, the South has spent 400 billion won ($360 million) in infrastructure construction while private enterprises poured 560 billion won ($500 million) into setting up plants and other provisions. Investors must have recouped part of their stake already but if the complex is permanently closed, they will lose a business opportunity that originally was guaranteed for 50 years.

 

Meanwhile, South Korean enterprises would lose the advantages of relocating in Kaesong. They would have to compensate customers for failed delivery of Kaesong-made products and return to the unforgiving business environment of the South, where their survival would be tenuous. Moreover, some 6,000 suppliers to Kaesong operations would lose a revenue stream. 

 

The opportunity cost in building up Kaesong instead of keeping the investment outlays inside South Korea may also have to be considered. One study calculated that total investment in the complex as of 2009 amounted to 730 billion won, which could have yielded net production worth 630 billion won had it stayed in the South.

 

On the political front, permanent closure would result in the breakdown of inter-Korean relations and a return to the era of blind confrontation like decades back. There would be no trace of inter-Korean economic cooperation and no opportunities for investment in North Korea could be found for a considerable time.

 

North Korea’s primary loss would be in wages, which totaled $90 million last year. Some 54,000 North Koreans assigned to Kaesong will lose their income and become unemployed. It is a loss that the hobbled North Korean economy can ill afford.

 

The bigger consequence for the North will be the crippling impact on future foreign investment in the country. The North will lose international trust, leading to much greater hesitation to lend money to the country or invest there.

 

Either the North or the South will be held responsible for erasing a symbol of inter-Korean cooperation and hope if a permanent closure transpires. Pyongyang has been trying desperately to have the blame pointed at Seoul. It is because the Kaesong complex is part of Kim Jong-il’s legacy and its closure would betray his lasting authority. 

 

3. Future Prospects

 

Both Koreas are reluctant to terminate the joint project. The North continuously states that “the responsibility for the present situation with the Kaesong complex lies entirely with the South.” The South Korean government and ruling party also maintain that the Kaesong complex should not be closed down. A further worsening of the situation is possible with the North confiscating all the assets in the complex and the South cutting power and water supply to it.

 

However, if the Kaesong complex remains closed too long, it may become irrevocably inoperable even without a formal decision. Although the situation varies among the manufacturers, if the complex is reopened within the next two to three months, normal operation will be possible with the replacement of machinery parts and return of buyers. But after three months, restarting plant operations would cost as much as the initial investment. Few enterprises would dare risk so much again.

 

Both Seoul and Pyongyang have insisted that the other side should change its attitude and make concessions. Both believe that one concession would lead to another. Both are waiting for the other side to blink first.

 

Fundamentally, Pyongyang raised the question of the joint industrial complex in an attempt to secure a position of strength in future negotiations with the United States and to hold the initiatives in dealing with the new administration in Seoul. But their scheme seems to have gone awry as the Park Geun-hye government refused to take a flexible stance toward the North. However, it is unlikely that North Korea will change its strategy at the moment. Considering the systemic rigidity in the North, it can hardly be expected that Pyongyang will take steps toward normalizing the complex unless the South offers them some excuse to do so.

 

The South Korean government is applying a principled stance on the Kaesong issue. During her conversation with editors of newspapers and broadcasters on April 24, President Park said that her government would “end the vicious circle of making concessions to the North upon its intimidation in brinkmanship tactics.” She stressed that there would be no more compromise just to pass a stalemate and that Kaesong would be an indicator of how the relations between the South and the North should develop in the future.

 

It is the unswerving position of the Park administration that the North should make the right choice to resolve the Kaesong problem. The door to dialogue is open and the North should withdraw its unjust and unreasonable measures so the complex will return to normal operations, the Seoul authorities say. There is little likelihood that the South will take any hasty action to seek the settlement of the Kaesong problem.

 

V. Conclusion

 

The Kaesong complex is the only successful model of joint venture in the entire 25-year history of inter-Korean economic cooperation. It is a mutually beneficial project that ensures a win-win relationship. The complex helps improve and develop ties between the South and the North, promotes reform and openness in North Korea, reduces military tension on the Korean peninsula, and changes the North Korean people’s perceptions on the South.

 

For the time being, the South should avoid taking any action to aggravate the stalemate, such as stopping power and water supply to the complex. Nor should the North attempt to seize the South Korean assets in the complex as they did at the Mount Kumgang Tourist Region.

 

It is necessary for both Seoul and Pyongyang to maintain the channel of dialogue, even at the lowest level, on Kaesong. Working-level contacts should continue to handle such affairs as checking communication lines, shipment of finished products from the complex, entry of electric and piped water technicians to the complex, etc.

 

The South Korean government should make efforts to raise people’s concerns about and support for the normalization of the Kaesong complex, manifesting strong intent to maintain the joint industrial project and persuading those with opinions in favor of its closure. It is worth noting that the Lee Myung-bak administration’s measures on May 24, 2010 to retaliate the North’s military provocations spared Kaesong from a package of economic sanctions. Unlike trading or bonded processing facilities, the nature of the Kaesong complex makes it difficult to restore operations once they are suspended. The government may well not pursue an immediate and unconditional resumption of operations, but authorities should listen to the concerned voices that its resurrection will be impossible after a few more months of “temporary closure.”

 

Kaesong is a sub-issue of inter-Korean relations so any moves to solve it should be undertaken from the broad approaches on the South-North problems. Government strategists should make deeper soul-searching on the fundamental problems of inter-Korean relations, listening to the complaints that the new administration has yet to show a grand roadmap on the question of South-North relations, peace and reunification of the Korean peninsula.

 

As an initial step to tackle the complex problem, it may be necessary to offer humanitarian aid to the North to help change the current confrontational atmosphere. The government has repeatedly stated its principle that humanitarian assistance will continue regardless of changing political situations.

[National Strategy 19-2, Summer 2013, published by the Sejong Institute]