On July 16^th, the official North Korean media reported that General Ri Yong Ho, the military’s Chief of the General Staff, had been dismissed of all duties.  Reports suggested that the general had been removed due to illness.  General Ri was a close confidant of the late Kim Jong Il and was thought to be tasked with smoothing the transition of the new leader of North Korea, Kim Jong-un, the “Young General.”  Ri’s exit, along with other events, suggests changes in the Hermit Kingdom.

Kim Jong-un, son of Kim Jong Il, has been receiving significant media attention.  He was seen at a rock concert given by an all-girl North Korean band (The Moranbong Band), whose members, according to reports, were “scantily clad.”  North Korea under Kim Jong Il was a rather prudish place, thus this display is seen as a surprise.  And, Kim Jong-un has also taken a wife, Ri Sol Ju, who has been accompanying the Young General to these events. 

The new leader of North Korea (thought to be only 28 years old) has clearly been busy.  There was little known about him when he took control after his father died last year.  It was assumed that he would be slow to put his stamp on the country; Kim Jong Il mourned for three years before he began to establish his control. 

In this report, we will discuss the significance of the ouster of Ri Yong Ho, the slow shift in the North Korean economy and the potential for significant change.  As always, we will conclude with potential market ramifications.

The Ouster

General Ri Yong Ho was the Chief of the General Staff for the Korean People’s Army (KPA).  He was a close confidant of Kim Jong Il; in fact, the general rose in rank quickly during Kim’s reign.  Apparently, General Ri had a serious disagreement over the future management of the economy.  Kim Jong-un decided to have him relieved of command; according to reports, the general deployed his bodyguards in a firefight to prevent his removal.  This action failed to prevent Ri’s ouster.  Officially, as noted, Ri stepped down due to illness.  Historically, North Korean officials stay in office when ill until near death.  Leaving due to illness is akin to a U.S. CEO stepping down to pursue other interests.

The ouster of Ri is significant.  Although the Kims appear to be dictators with nearly complete power, in reality, they must manage various power centers.  The two primary ones are the KPA and the Workers Party of Korea (WPK).  Essentially, the Kims must protect the dynasty from civilian revolutions and military coups.  Kim Il Sung, Kim Jong-un’s grandfather, was a revolutionary military leader.  This gave him credibility among military leaders and allowed him to rule through the WPK.  The primary economic system Kim Il Sung developed was juche, which is best described as self-reliance.  The North Korean economy was mostly autarkic; its primary trading partner was the Soviet Union.

Kim Jong Il did not have a military background and was generally not held in high regard by military leaders.  To placate the military, he developed a system called songun, which means “military first.”  Essentially, the military was given first priority for government spending and was called the vanguard of the revolution.  Songun was considered a deviation from juche, in that the WPK was given priority in the latter system. 

However, near the end of his life, Kim Jong Il concluded that the military had become too powerful.  Thus, he began to work to rebalance the government back to the WPK.  In 2010, Kim Jong Il called a special session of the WPK (only the third special session in North Korean history and the first in 44 years).  He used this session to begin reducing the power of the KPA.  However, Kim Jong Il did not move rapidly to make this shift, likely because he was worried he would not live long enough to complete the adjustment and his son would be unable to do so.

When Kim Jong-un replaced his father last year, it was generally expected he would move slowly to consolidate power.  Clearly that assumption was wrong.  Removing General Ri, who was said to be a vociferous supporter of songun, appears to be designed to move the process along quickly.  The new North Korean leader seems to be comfortable enough in his authority to oust the general. 

It has been noted that Kim Jong-un looks much like his grandfather, who was held in higher regard than Kim Jong Il.  As noted earlier, the new leader also seems to be more comfortable with his public role.  His father was a shy political figure, mostly shunning visits to state facilities and “pressing the flesh” with his comrades.  Kim Jong-un seems to relish meeting the public, clearly enjoying visits and appearances.  It seems the public is embracing the social openness that was stifled during Kim Jong Il’s reign.  The best we can gather is that North Koreans seem to like the new leader and his resemblance to his grandfather, the “Great Leader,” and are perhaps offering support for his new policies.

The Shift in the Economy

North Korea is a poor nation; the CIA Factbook puts its per capita GDP at $1,700 per person, the same as the Ivory Coast. 

(Sources:  PlantetObserver/Science Photo Library)

This satellite picture shows the contrast of North Korea to South Korea and China.  This night picture shows the lack of electrification in the Hermit Kingdom as a dark void. 

Kim Il Sung’s juche system allocated goods and services by rationing.  Older North Koreans have noted that there was little need for money.  Resources were rationed by perceived loyalty.  Those with the best relations with the regime received the most goods and services.  These were ranking military and party leaders who had impeccable lineages.  North Koreans who had fought in the revolution or during the Korean War and who were not known to have circulated with Americans, South Koreans, Japanese or Chinese had the greatest access to resources.  The middle tier were generally considered to be loyal but had some blot on their lineage, such as contact with the above.  The bottom tier were considered suspect.  They would have been considered collaborators with the Chinese or the Japanese.  This lowest tier usually lived outside of Pyongyang in the rural areas. 

Citizens who tried to defect or were caught moving across the Russian or Chinese borders could fall into the lowest rank.  The government punished for three generations.  Thus, a defector’s parents, wife, and children would all be punished.  A person in the highest rank would be reluctant to stray because they would not only lose access to material wealth but would also bring shame and punishment to their families.  Through the mid-1990s, North Korea was tightly controlled. 

It is interesting to note that ethnic Koreans who were living in China would often try to cross the border into North Korea because living conditions tended to be better than in China.  This was especially true during Mao Zedong’s famous mistakes, like the Great Leap Forward and the Cultural Revolution. 

Although the official policy was self-reliance, North Korea was very dependent upon the USSR for economic growth.  In 1988, 60% of North Korea’s foreign trade was with the USSR.  The collapse of the Soviet Union dealt a severe blow to North Korea; it lost access to energy resources and agricultural minerals. 

In the mid-1990s, North Korea was hit with a severe famine.  The proximate cause was flooding; floods in July 1995 were described as being of biblical proportions.  In the North Hwanghae Province, nearly three feet of rain fell in just over seven hours.  Not only were fields flooded, but underground grain storage centers were inundated as well.  Estimates suggest that at least 3.5% and perhaps up to 15.2% of the population perished. 

Although the regime was never in danger during this period, there was a pronounced change in civil order.  First, Kim Jong Il clearly implemented the songun policy; the military received preferential treatment in terms of food supply.  The severe famine led the military to grow its own crops.  Independent agriculture and other forays into industry meant the songun policy expanded the military’s control over the economy.  Second, a culture of bribery developed.  Honest bureaucrats, who distributed resources according to instructions, perished.  The dishonest civil servants, who took bribes in return for favors, survived.  Money, which had not been central during Kim Sung Il’s reign, became increasingly prevalent. 

The expansion of money and bribery facilitated the development of a black market.  Entrepreneurs bribed border guards to allow them to cross and return with Chinese goods, which were sold in private markets.  Although technically illegal, the corruption of bureaucrats allows this black market to flourish.  In fact, without the black market, it is doubtful the economy would function.

Media reports indicate that Pyongyang’s economic situation has improved significantly.  Stores are said to be well- stocked and cell phones (more on this below) are ubiquitous.  Much of this improvement has come from the private market which is facilitated by bribery.

In 2009, Kim Jong Il tried to bring this private market down by issuing new currency.  For the first time in 50 years, the NKW was revalued in November 2009 at a ratio of 100-1.  The program was a disaster.  There were limits on how much the government would allow to be converted into the new currency, effectively wiping out the savings of most households.  At black market exchange rates, the government only allowed about $30 to be converted, leaving citizens with perhaps millions of worthless won.  Civil order was generally maintained, although there were reports of a rather large riot in the city of Hamhung where 12 instigators were later executed.  However, after this event, the government dramatically eased the conversion conditions, essentially admitting the program failed.  The bureaucrat in charge of the effort, Pak Nam-gi, was reportedly executed on March 17, 2010.  It should be noted that there are unconfirmed reports that Kim Jong-un supported the revaluation.  If so, this may provide some insight into his policy tendencies.

Not So Much a Hermit Anymore

One of the assumptions open societies have when dealing with closed totalitarian states is that information is dangerous to such nations.  The creation of Radio Free Europe and its counterparts was designed to beam news into communist states to give these citizens an alternative to the slanted state news bureaus.  In general, the belief was that if these oppressed people could see the way the world really is, they would eventually rebel.

These totalitarian states viewed this outside media as a threat. In North Korea, having a tunable radio is against the law; radios are permanently tuned to the state radio station.  In the USSR, there were strict controls on copying machines; authorities wanted to control the distribution of information. 

However, the internet and social media have made it increasingly difficult for totalitarian regimes to control information flow.  The Arab Spring and the color revolutions used social media and the internet to organize themselves to rebel against totalitarian governments.  Social media and the internet are potent tools against totalitarianism.

Most analysts believe the distribution of outside information is a necessary but insufficient condition for revolution.  Although North Korea remains relatively isolated compared to the rest of the world, it’s much better integrated than most believe.  Due to the expansion of private markets, DVDs, MP3s and USB sticks are widespread.  There are nearly one million cell phone subscriptions in North Korea.  Chinese and South Korean movies and soap operas are standard fodder.  Unlike the defectors of a decade ago, anyone leaving North Korea today has a fairly good idea of how things are in other places. 

Essentially, the expansion of private markets undermined the regime’s ability to control information.  So far, the government isn’t cracking down on the proliferation of media hardware.  It is likely that it doesn’t mind the diversion simply because it isn’t likely to change its citizens’ minds, at least in the short run.  It should be noted that Cuba has vacillated between markets and central control, although recent changes under Raul Castro seem to lean toward markets as a permanent policy. 

What this means for Western policymakers is that simply sending information into North Korea won’t necessarily end the regime.  Until the North Korean people believe there is a viable alternative to the government that is better than what they have now, Chinese movies are not a threat.

The Potential for Change

Kim Jong-un clearly exhibits a warmer personality than his father; in that regard, as we noted, he is much like his grandfather.   In addition, he appears to be rapidly putting his own stamp on the North Korean regime.  The ousting of Ri Yong Ho was unexpected, and he has been putting his own allies in powerful positions.  This rapid pace of transition was generally not anticipated.

The Young General is moving away from his father’s songun policy in a bid to bring more balance between the KPA and the WPK.  Thus far, he has not moved against the private markets either. 

Essentially, North Korea has maintained power by following three tactics.  First, the regime carefully crafts a madman image.  Although an analysis of their behavior belies this image, it works well for them.  North Korea’s neighbors are not sure if it would do something crazy if provoked.  Virtually everything they do is measured, but the Kims are masters at making it look like they could do something irrational at any time.  Second, they know the region would not want to see the regime collapse; South Korea has seen the costs Germany absorbed to integrate the eastern region when the Berlin Wall fell.  South Korea doesn’t want to take on that burden.  China would not want a refugee crisis on its border either.  Thus, the North Korean government regularly warns that they face a humanitarian crisis that might spin out of control.  This is done as a form of extortion.  Third, North Korea has nuclear weapons.  Although the U.S. hates to admit it, North Korea will probably never be attacked because it possesses these weapons.  The U.S. fears the North Korean example is being followed by Iran.

We see no sign that Kim Jong-un will change this pattern.  These three legs have kept the regime safe from foreign invasion.  In addition, it has also eased outside pressure.

As noted above, both South Korea and China fear a collapse of the regime.  At the same time, it is generally believed that North Korea will eventually need to be integrated into the global economy.  Both have worked to offer investment in North Korea to boost growth.  There are Special Economic Zones set up by both countries in a bid to improve the economy.  China, facing rising labor costs, has shown interest in shifting some production to the lower-cost North Korea.  And, China is interested in developing North Korea’s natural resources.  The Kims have tended to treat these offers carefully, making sure North Korea does not become overly dependent upon either country.  At the same time, the investment offers found money for the North Korean elites.  As more consumer goods enter the economy, the desires for acquiring will likely rise as well.  The more development the rest of the world can generate in North Korea, the threat of a regime collapse diminishes. 

 

Ramifications

The market ramifications of this situation are a potentially better investing environment for the nations that surround North Korea.  When the regime makes threats, the currencies and equity markets of surrounding nations weaken.  Although we still expect Kim Jong-un to maintain policies similar to his father and grandfather, there is a chance that the shift away from the military and toward the WPK will slowly open the economy to foreign investment from China and South Korea. 

What investors should not be taken in by is the social personality of Kim Jong-un.  He remains like his predecessors.  However, we do expect he will continue to allow the growth of private markets, which should improve economic conditions over time.  We do not expect the Young General to do anything radical to prompt a regional conflict either.  Overall, there should be some softening of conditions but no major changes. 

 

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

 

 

(c) Confluence Investment Management

www.confluenceinvestment.com

 

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