With the North Korean government set to borrow somewhere in the region of 60% of the value of its entire budget this year through its first bond issue since 2003, North Korea may see a return to rapid inflation like it saw in the 2001-2012 period.

If this actually happens it could have highly negative consequences for the economic outlook, with enterprises and entrepreneurs (Donju) set to be forced to finance this bond issue, which will likely have the effect of crowding out productive investment.

It’s still a big if as to whether the Kim Jong Un government will actually institute such a massive change in government fiscal policy after eight years of price stability and what appears to be fiscal responsibility, but if it does, we should hold on to our hats, because what comes next could be very grim for the North Korean people.

Let’s not forget that this is a government that takes pride in not paying its debts, both to foreign and domestic creditors (via inflation). It also did not prove itself averse to outright asset confiscation via currency reform back in 2009, so things could get very ugly indeed. Here’s why.

The shallow roots of price stability

Since 2012, the North Korean economy has enjoyed a period of relative price stability and a stable exchange rate. We do not have detailed consumer or producer price indices for the country – because the North Koreans are smart enough not to release such fascinating information. But data collected by Daily NK and NK Pro both indicate that the Korean Won is stable against the dollar.

And the Daily NK time series also indicates that fuel prices have been largely stable over the past-half decade, and food prices have actually been in decline over this period relative to global prices.

Some experts, like William Brown, have argued that the downward trend in food prices may actually be a consequence of a sanctions-induced recession forcing households to cut back. Chinese aid may also explain some of these downward movements, as well as perhaps by rising harvests, as Kim Jong Un claimed in January.

The stability of food and the exchange rates would also seemingly point to a combination of aid and smuggling plugging the gap between the official trade deficit and what the economy actually consumes. And of course there are also plenty of other illicit economic activities that the regime is rather adept at engaging in, as the UN Panel of Experts reports catalog.

Here’s the rub though: North Korean merchandise exports and imports require their partners to have demand for their goods and to be willing and able to supply the North Koreans with the imports they want. Chinese supply chains worldwide have been significantly impacted by factory closures, Chinese demand for textiles (a key North Korean export to China) are way down, for instance.

North Korea’s access to Chinese manufacturers may very well be on the blink – as trade data indicates. The response of consumers in Pyongyang has been to panic buy imports, as both Daily NK and NK News reporting indicates.

In the short-run, the value of the Won may rise if households are forced to substitute imports for domestic produce that is more likely to be sold in Won at state shops.

Pyongyang has got to hope that the Chinese appetite for their merchandise exports, smuggled or otherwise, and North Korean services (tourism, IT et al.) revives quickly, or at least imports from China can normalize.

Otherwise, as shortages of imports continue, we may see consumer prices go up, but also producer prices rise as well. Producers will be clobbered by something else too, though.

Bond sale or super tax on producers?

If imported inputs remain difficult to source, as is evidenced by the rise in fuel prices that has been seen since January, then producer prices in general are liable to rise. As Ben Silberstein pointed out recently, North Korean producers appear to already have been hit by the Coronavirus shock, and this is potentially a double shock – supply from China and demand from the Chinese market. The state has seemingly moved to make things all that much worse, imposing what amounts to a super tax on producers.

The bond issue that is set to go ahead will equate to 60% of the national budget. North Korea’s budget can be estimated to be slightly more than 25% of GDP if official numbers, exchange rates and GDP figures are taken seriously. This means the North Korean government is set to borrow something like 15% of GDP, and this borrowing will take the form of 60% in-kind (supplies given by enterprises/state institutions to the state) and the other 40% in foreign currency (from entrepreneurs).

It is unlikely that the state will spend these borrowed funds and resources on the same things that enterprises and entrepreneurs would have. Given the North Korean state’s penchant for large pet projects, it’s more likely that much of this money will be wasted on frivolous white elephants.

Enterprises will be made poorer by this, dispossessed of valuable supplies, while entrepreneurs will lose potential investment funds and working capital for their businesses. This is liable to hit the ability of producers to supply their customers, and thus drive up consumer prices and prices for producer goods as well – factories and farms make inputs for other factories too.

This might be offset by the fall in demand that may result from the loss of productive capacity – workers will be paid less, and entrepreneurs will make smaller profits meaning they have less to spend. So perhaps the impact on take-home pay and profits will offset the loss of production.

Perhaps the prospect of deflation should concern us more, given a collapse in demand, and this is a serious possibility for many economies worldwide. But the depth of the supply shock in North Korea may be ultimately outstrip the demand shock.

Nominal prices (in Won) are liable to spike and prices in dollars could spike as they have in other countries hit by a supply shock. The government pays workers their rather nominal salaries in Won, and Won can still be used for smaller purchases. There may be some lag in this phenomenon, with Won prices temporarily dipping due to increased demand for domestic, won-priced goods to replace lost imports. However, longer run, it’s difficult to see how reckless borrowing by the state will not debase the value of the Won and spark inflation.

If there is a sudden de facto confiscation of foreign currency via compulsory bond purchases, this will likely make foreign currency more scarce and thus more valuable especially at a time when imports are in short supply.

There is a plausible case for a vicious circle ensuing, the first signs of which already appear to be evident. The price of foreign currency-denominated imports rises in real terms as supply shocks from China hit markets and foreign trade enterprises. Foreign currency revenues from exports to China collapse as even smuggling and illicit trade is curtailed due to the Coronavirus.

And at this, combined with forced sales of FX-denominated government debt lead to a sharp contraction of the supply of foreign currency and thus a steep rise in the exchange as Dollars and other FX becomes more valuable relative to Won.

Hope against hope

Reporting from Daily NK is good evidence that the bond issuance is on the way. Let’s hope that the size is smaller, far smaller, and that it is voluntary rather than compulsory.

While sight of North Koreans being forced to buy government bonds will be grim enough, if Pyongyang goes through with what is allegedly planned, this could be an economic disaster for North Korean entrepreneurs, enterprises and their workers.

Even if Chinese demand for exports recovers and/or the supply of Chinese imports is rebounds, a sudden and sustained spike in exchange rates sparked by this forced bond issue could freeze up North Korean markets. We could see the North Korean equivalent of a dash for (foreign) cash, with traders refusing to sell except in foreign currency.

The Won, which remains the currency that many poor people are often paid in, and a currency used in many state shops, could go into rapid decline again (like it did post-2001), and the price of other supplies, both imports but even domestic produce rise rapidly.

Enterprises without the inputs they have been forced to give to the state as part of the bond purchase cannot produce, while entrepreneurs cannot invest with the FX they have been forced to hand over. Here’s hoping that the North Korean government isn’t about to do what sanctions have thus far failed to: create a full-blown general economic crisis.

Edited by Oliver Hotham