Networks, Trust and Trade: The Microeconomics of China–North Korea Integration

• DOI: http://doi.org/10.1111/asej.12159
• Author: Stephan Haggard,Marcus Noland
• Date: 01 September 2018
• Published date: 01 September 2018

Networks, Trust and Trade: The Microeconomics

of China–North Korea Integration*

Stephan Haggard and Marcus Noland

Received 24 March 2017; Accepted 1 June 2018

A central hope of engagement with North Korea is that increased cross-border

exchange will encourage the strengthening of institutions and, eventually, a mod-

eration of the country’s foreign policy. An unprecedented survey of Chinese enter-

prises operating in North Korea reveals that trade is largely dominated by state

entities on the North Korean side, although we cannot rule out de facto privatiza-

tion of exchange. Little trust is evident beyond the relationships among Chinese

and North Korean state-owned enterprises. Formal networks and dispute settle-

ment mechanisms are weak and do not appear to have consequences for relational

contracting. Rather, firms rely on personal ties for identifying counterparties and

resolving disputes. The results cast doubt that integration between China and

North Korea, at least as it is currently proceeding, will foster reform and opening.

Keywords: trust, relational contracting, economic integration, institutions; China,

North Korea.

JEL classification codes: P33, P25, L14, F15.

doi: 10.1111/asej.12159

I. Introduction

Modern market economies would break down quickly if all transactions were

consummated at the time of sale. Market transactions thus rest on the expecta-

tion that counterparties will fulfill contractual obligations that unfold over time,

whether in the context of an investment relationship or with respect to fulfill-

ment of orders and payment for product. Particularly important to the function-

ing of a market economy in this regard are the extension of credit and the

institutions that support it.

The policy environment and formal institutions, including dispute settlement

mechanisms, matter to enforcing such contracts. Institutional quality has been

*Haggard: Graduate School of International Relations and Pacific Studies, University of Califor-

nia, San Diego, 9500 Gilman Drive, La Jolla, CA 92093-0519, USA. Email: shaggard@ucsd.edu.

Noland (corresponding author): Peterson Institute for International Economics, 1750 Mass. Ave.

NW, Washington, DC 20008, USA. Email: mnoland@petersoninstitute.org. We would like to thank

Alex Melton for research assistance and an anonymous referee for comments on an earlier draft. This

work was supported by the Smith Richardson Foundation and Academy of Korean Studies grant

AKS-2011-R39.

© 2018 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2018, Vol.32 No. 3, 277–299 277

found to affect the volume and commodity composition of international trade,

including in the particular cases of China and North Korea (Levchenko, 2007;

Feenstra et al., 2012; Haggard et al., 2012). Informal institutions can also com-

plement formal institutions or even substitute for them altogether where they are

lacking, however. Networks are key informal institutions that can facilitate trust.

The development of cross-border market exchanges and institutions is of par-

ticular interest in economies undergoing reform, and both for economic and

political reasons. The external sector can play an important role in the reform

process, as it did in the export-oriented economies of East Asia. It is possible

that in closed economies the expansion of exchange could yield transactions that

are not only market-conforming but effectively private in nature. The develop-

ment of a de facto private cross-border market economy would be accompanied

by increasing trust among firms, manifest in longer-term relational contracting,

and the willingness to extend credit to counterparts and to invest directly. Cross-

border exchanges would ultimately generate economically rooted political inter-

ests that would constrain or encourage the North Korean regime to undertake

further economic reform and develop supportive market-conforming institu-

tions.

1

However, there is also a counterargument that if one of the trade partners

has a strong technological advantage in the institutionally intensive good, as

China presumably has vis-à-vis North Korea to day, then opening to trade will

not strengthen the institutional quality of either partner (Levchenko, 2011).

Moreover, incumbent governments may have little interest in the development

of either informal or formal market-supporting institutions, even though forego-

ing them carries substantial opportunity costs (Wei, 2000; Anderson and Mar-

coullier, 2002; Moenius and Berkowitz, 2011). Such developments might

threaten the state’s capacity to maintain control or to extract rents through cor-

ruption. Indeed, authoritarian incumbents are likely to structure economic

exchanges, precisely so they maximize, control and limit the risks associated

with the emergence of markets, informal and formal institutions, and economic

reform.

The dramatic expansion of China–North Korea trade provides a particular

opportunity (indeed, a virtual natural experiment) to consider some of the effects

of cross-border exchange on the development of relational contracting and infor-

mal and formal institutions. Traditionally, trade between the two centrally

planned economies was small and politically determined. The breakup of the

Soviet Union, the dissolution of the Eastern Bloc and the apparent inability of

the North Korean leadership to adjust to changing circumstances contributed to

an implosion of North Korea’s economy and a famine that killed as many as one

million people: around 5 percent of the pre-crisis population (Haggard and

Noland, 2007). The inability of the state to provide food under the existing

socialist compact forced small-scale social units (households, work teams, local

1 See Johnson et al. (2007) for an example of the claim of the institution-enhancing impact of

international trade in a non-North Korean context.

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