Since 2000, Korean firms’ R&D investment have recorded an annual increase of 12.7% and accounted for 78% of total R&D investment in Korea, which surpasses that of U.S., Japan, and China. On the other hand, Korean firms’ exports and outward foreign direct investment (OFDI) have steadily increased to record 562 billion and 24 billion dollars in 2013, respectively, which accounts for more than 50% of total GDP. Given the fact that the Korean economy heavily relies on firms’ R&D investment, exports and OFDI, our report provides in-depth analysis on the effects of R&D investment on exports and OFDI by using a rich set of Korean firm-level data. In particular, by considering the results from prior trade literatures that analyzed the effects of R&D investment on firm productivity and that examine the effects of firm productivity on exports and OFDI, we analyze the effects of R&D investment on exports and OFDI by incorporating firm productivity as a mediator.
In examining the effects of R&D investment on firm productivity, we first measure R&D investment as firms’ total expenditure on R&D activities, while measuring firm productivity using total factor productivity, capital productivity, and labor productivity. Using these measures, we find that R&D investment significantly increases firm productivity. In particular, to analyze how firm R&D investment affects its productivity-level over time, we use lagged R&D variables to estimate their effects on current productivity-level. As a result, we find that current and previous R&D investment have positive and significant effects on current productivity-level and that its magnitude becomes larger over time. In other words, firm productivity is significantly and largely associated with prior R&D investment. Alternatively, estimating the effects of R&D investment on firm exports using lagged variables, we find that R&D investment have positive and significant effects on current exports and that its magnitude becomes larger as R&D investment is made in prior. Evaluating the effects of R&D on OFDI through lagged R&D variables, our results show that R&D investment made in prior years significantly increases the current amount of OFDI and also raises the probability of firms’ engagement in OFDI in the current period.
To provide in-depth analysis on the effects of R&D investment on firm’s exports and OFDI, we use path analysis methodology to estimate the effects of R&D on exports and OFDI with and without incorporating firm productivity as a mediator variable. Our estimation results show that firm R&D has positive and significant direct and indirect effects on exports and OFDI through the increase in total factor productivity. Estimating the magnitude of direct and indirect effects, we find that firm R&D investment is more effective in increasing exports and OFDI directly than indirectly through firm productivity increase.
Given the fact that R&D intensiveness is different across industries, we perform the same estimations at the industry-level. Our estimation results show that firm R&D investment has significant positive direct and indirect effects through firm productivity on exports and OFDI among capital-intensive industries, namely, electronic components, auto-vehicle, and machinery equipment industry sectors; while it has insignificant direct and indirect effects within labor-intensive industries, such as textile and paper. Among capital-intensive industries, in particular, we find that firm R&D investment is more effective in directly increasing exports than OFDI in most sectors, while it is more effective in increasing OFDI than exports through firm productivity improvement in the auto-vehicle and machinery equipment sectors.
Our analysis provides significant policy implications on firm R&D investment. First, our estimation results that firm R&D significantly increases the productivity, exports and OFDI imply that R&D promotion policies towards the private sector are effective in improving firm performance and that more favourable policies towards firm R&D investment should be considered. Second, our findings that the magnitude of firm R&D effects becomes larger over time indicate that firms and governments should evaluate its effect from a long-term point of view. Third, policies that are designed to promote firms to invest in R&D activities would be more effective for capital-intensive industries than labor-intensive industries. Our results that direct and indirect effects of R&D on exports and OFDI are significant in capital-intensive industries imply that while promoting firm R&D investment in capital-intensive industries is effective, alternative measures should be considered to increase exports and OFDI in labor-intensive industries.

Since the Asian financial crisis of 1997-98, the East Asian countries have made efforts to guard against the crisis not only by being self-insured through the accumulation of foreign reserves but also by establishing a bilateral or regional financial safety net through the pooling of reserves. Holding ample amount of foreign reserves has proven itself to be useful but it comes with a high price tag. Moreover, in spite of noticeable achievements in recent years, the regional financial arrangement, namely the CMIM framework, had not been activated during the global financial crisis in 2007-08. Ironically, the bilateral currency swaps with the US Federal Reserve Bank played a pivotal role at that time in addressing some Asian countries’ liquidity shortages.
The crisis in 2007-08 has provoked a recurring discussion about the necessity of transforming the international monetary system and enhancing the alternative or complementary insurance mechanism of regional financial arrangements to fend off shocks. In the paper, we propose two ways to strengthen a regional financial arrangement in East Asia to make a practical contribution to the global architecture reform agenda and to build a resilient economy: (i) establishing a currency arrangement under CMIM framework to increase the usage of local currencies; and (ii) creating a cooperative framework between the AMRO and the IMF in the area of surveillance.

Preface
Contributors
Introduction and Overview
Statements by Hosts and Country Representatives

Part I. Regional Economic Cooperation in Northeast Asia: Country Perspectives
- A Korean Perspective (Chang Jae Lee) 
- A Chinese Perspective (Zhang Jianping)
- A Japanese Perspective (Maeda Tadashi)
- A Russian Perspective (Pavel Minakir)

Part II: Energy Cooperation: Energy Infrastructure and Physical Connectivity
Japan’s Energy Challenges and Potential for Regional Cooperation (Tanabe Yasuo)
Energy Issues: Security, Alternative Systems, and Low-Carbon Futures (Terry Surles)
Prospects for a Cross-border Power System in Northeast Asia (Iinuma Yoshiki)
Energy Cooperation in Northeast Asia: A Russian Perspective (Sergey Sevastianov)

Part III: Regional Cooperation and Integration
Regional Cooperation and Integration in East and Northeast Asia (Kilaparti Ramakrishna)
Cultivating Multilateralism in East Asia (Iwatani Shigeo)
Regional Integration in Northeast Asia (Wang Weina)

Part IV: Financing Regional Economic Integration through Cross-border Infrastructure Construction: Review and
New Approaches to Regional Multilateral Financial Institutions

Keynote Statement—Fulfilling a Long-held Dream: Financial Policy for a Unified Korea (Shin Je Yoon)
A Strategy toward a Regional Multilateral Financial Institution (Lee Jai-Min and Kim Yu-Ree)
Establishing a New Development Financing Institution: Comments and Observations (S. Stanley Katz)
Northeast Asian Financial Cooperation in a New Era (Fan Xiaoyun)
Comments on Financial Cooperation in Northeast Asia (Zou Ping)

Part V: Cross-border Economic Cooperation: Tumen River Area Economic Integration for the Korean Peninsula

Political and Economic Imperatives behind North Korea’s Evolving Special Economic Zones (Glyn Ford)
Underdeveloped Sino-Russian Cross-border Cooperation (Natalia Ryzhova)
Creating a Northeast Asian Economy (Tony Michell)

Appendix I. Seoul Declaration and Agenda
Appendix II. Planning Meeting Summary and Agenda
Appendix III. Report of Field Visit to Rason Special Economic Zone, DPRK and Yanbian, China

The Northeast Asia Economic Forum (NEAEF) is a regional nongovernmental organization created in 1991 to sponsor and facilitate research, networking, and dialogue relevant to the economic and social development of Northeast Asia. The Forum is also committed to promoting understanding and relations among the peoples of Northeast Asia, North America, and Europe.
The main objective is for NEAEF to conduct research and conference activities aimed at functional economic cooperation such as cross-border energy, transportation and logistics infrastructure development, and capital mobilization. The Forum holds annual conferences, workshops, and seminars for planning, facilitating, coordinating, and implementing international and interdisciplinary solutions to common policy problems. It is the only nongovernmental regional organization in which all the nations of Northeast Asia and the US are consistent and active participants.
For the year 2014, NEAEF in collaboration with the Korea Institute for International Economic Policy (KIEP), cooperated in efforts toward achieving closer economic and financial cooperation in Northeast Asia, and continued its focus on research, the annual conference, and meetings aimed at financing regional economic integration and establishment of the Northeast Asian Bank for Cooperation and Development (NEABCD). This work aims to promote functional economic cooperation in terms of cross-border resources, energy supplies, infrastructure construction, capital mobilization, and institutional development.
NEAEF, as planned for the year 2014, facilitated conference and meeting activities in which experts presented their perspectives, views, ideas, concrete proposals, and strategies relevant to the issues of a regional institution for financial cooperation.
This volume, which is the final part of a series of proceedings titled Financing Regional Economic Integration and Functional Cooperation for Northeast Asia: Toward a Northeast Asia Economic Community, presents the results of a project implemented in 2014 that includes presentations and summaries from the 23rd annual NEAEF conference and meetings, as well as related activities.

This study investigates the background and causes of the major changes in the labor market environment in Southeast Asia, while also identifying the characteristics of the labor market. In particular, the increase in foreign direct investment (FDI) in Southeast Asian countries serves as a starting point for this analysis, because the flow of FDI, we believe, is the most important cause of changing conditions in the labor market. In addition, we have explored whether the investment decisions of Korean firms are affected by the changes in the labor markets in the area, through both empirical analysis and a corporate survey on their strategies to respond to the changes. We find that Korean firms, particularly, small and medium sized enterprises, mainly focus on localization at the management level. Furthermore, based on the findings, we have proposed better ways to support the Korean firms operating in Southeast Asian markets.
In chapter 2, we have listed the causes of labor market changes in Southeast Asia. First, as increases in income made workers in the region to devote greater attention to democracy and human rights, the government could not ignore the workers' demands for higher pay and better working conditions. Second, the governments in the region have recognized that high external dependence may hinder sustainable development after the global financial crisis. Since the governments are aware of the necessities of expansion of domestic markets to avoid the risk, they have become noticeably pro-worker in terms of their labor policies. In addition, populist political activities also led to pro-worker policies. Since the changes in the labor market environment can reflect the needs of both the governments and their workers, in sum, we conclude that changes in the labor market environments will continue to occur for some time.
In chapter 3, we analyze the characteristics of the labor market structure in Southeast Asia as to labor supply and demand aspects. The features of labor supply in the region can be summarized as follows. First, this area exhibits a relatively high population growth rate as well as a high proportion of youth among the entire population. Second, the quality of human resources is expected to improve. In Vietnam, Indonesia, and Cambodia, where Korean corporations have been relatively active expanding their business compared to other countries, we have observed a rapid increase in the enrollment rate in tertiary education. Third, if the ASEAN Economic Community succeeds in its plan, skilled workers can migrate more freely within the region. The characteristics of labor demand can be summarized in the following two sentences. First, the structure of labor demand is becoming diversified in Southeast Asia. Second, we find that economic growth creates a number of jobs in the area through the elasticity of employment. In addition, comparing the wages of white-collar and blue-collar workers, we find that the white collar workers receive more wages than blue-collar workers across all countries. However, we could not confirm whether these wage differences are attributable to individual capabilities, due to limitations in the data.
In chapter 4, two analyses were carried out. First, we empirically analyze the Korean enterprises' determinants of foreign direct investment in Southeast Asia. Moreover, we investigate how they respond to the current changes in labor market environments through a corporate survey. According to the results of our empirical analysis, Korean firms continue to choose these areas as bases for labor intensive production process, despite the increase of local production costs such as labor cost. This result accords with survey results that the firms already working in these areas will not move, either back to Korea or to other countries. Interestingly, 57.3% of the companies responding to the survey answered that they overcame the recent wage increase through increase in productivity. Furthermore, where the labor market conditions are worsening, 73.3% of firms chose a localization strategy, such as productivity increases, to surmount the difficulties, rather than moving to other countries. The reason for these interesting results can be shown in the following two sentences. Firstly, the increase in variable costs currently being experienced is less than the increase in the fixed cost of relocation of production facilities. Secondly, countries that are generally considered as alternative locations, such as Myanmar, have also experienced similar changes in labor market environments.
Based on the above discussion, we believe that Southeast Asia still has potential for the inflow of FDI from Korean firms. Ongoing changes in labor market conditions in Southeast Asia are likely to have an adverse impact on Korean firms operating there, though the extent of the impact will differ across industries and technology levels. In chapter 5, therefore, we suggest that business support policies in overseas markets should widen the scope of their application, because current support policies tend to focus on supporting only the initial advances. Hence, for firms already operating in Southeast Asia to successfully expand their markets, the Korean government should provide additional support measures for localization of these firms. Of course, since the companies located abroad do not use the domestic production process, the additional support of the firms located abroad may reduce the creation of domestic jobs. However, given the existence of previous research indicating that Korean firms' OFDI can positively affect domestic productivity and employment, the Korean government should identify the impact of additional support by industry.

Until the mid to late 2000s, the process of trade liberalization has been driven forward through ongoing efforts of world economies at the WTO level. At the same time, regional processes such as Free Trade Agreements (FTAs) have made greater liberalization possible, lowering tariff barriers significantly. With the world currently in recession, the global financial crisis has intensified competition. These difficulties therefore require practical efforts of countries to maintain the present pace of trade liberalization. In this regard, there is much debate as to the role of trade remedies in the process of recovery from the global financial crisis. Some countries tend to utilize trade remedies to protect the country’s declining domestic industries or vulnerable domestic industries. Korea launches anti-dumping investigations against imports originating from foreign countries, but at the same time Korean exporters have also been subject to the largest number of anti-dumping investigations in the United States, China and India. Accordingly, it is necessary to examine the economic effects of trade remedies from both the perspective of being subject to import regulations and the perspective of imposing import regulations. The frequent use of trade remedies has come under criticism due to the fact that the positive effects of trade liberalization could be negated. This study aims to draw implications and propose countermeasures for the efficient operation of the Korean trade remedies system, by analyzing the impact of trade remedies on imports and exports, and by conducting comprehensive analysis of operational issues regarding trade remedies. The trade remedy system is often established to correct unfair trade practices such as dumping and subsidies, or to provide temporary remedies to importing countries for emergencies or for exceptional circumstances such as safeguards. In a broader sense, the trade remedy system often includes unfair trade practice investigation. This study limits the scope of the trade remedy system to anti-dumping investigations, as the cases of countervailing duties or a definitive safeguard measure imposed by Korea on imports (subject merchandise) are extremely rare. While most of the previous studies that analyzed the effect of anti-dumping measures were focused on cases involving the United States, this study contributes to the literature on anti-dumping investigation by collecting data on anti-dumping investigation in China and India, in addition to the United States. Comparisons of the anti-dumping investigations in Korea and the United States, China, India during 1995-2014 led to the following results: the United States had less number of cases terminated by impositions of measures as a percentage of all the cases initiated, while China and India were subject to a relatively long period of anti-dumping investigation. One thing the anti-dumping investigations in the United States, China, and India have in common is that the exporters of subject merchandise and the exporting country subject to investigation are quite diverse. Related practices in Korea are developing fast, and it is comparable to those of the United States practice, showing a higher-level anti-dumping system than China and India. The United States has the most specific provisions relating to the non-market economy (NME) and the use of cumulative assessment of injury; the United States makes active use of these provisions. As for China, it strictly enforces price undertaking agreements. However, there is room for improvement regarding administrative review systems in China along with India. This study empirically investigates the existence of a chilling effect on imports and exports, and the impact of anti-dumping measures on imports and exports, identifying separate effects for each. The impact of anti-dumping measures on imports and exports were felt differently depending on the country's institutional characteristics, practices, and the industry subject to investigation. The results show that the Korean anti-dumping measures caused a reduction in the import volume at the HS-6 digit category of subject merchandises, a phenomenon found to be common across industries. Mere initiation of an anti-dumping investigation against Korea by the United States caused a substantial decrease in the total export volume of HS-6 digit products. The duration of the chilling effect depended on industry characteristics. China's anti-dumping investigation against Korea was focused on the chemical industry. The chilling effect on exports occurred, but only appeared for a short period. Similarly, India’s anti-dumping investigation against Korea caused a chilling effect on exports, which again disappeared in a short period of time. A cross-country comparison of the anti-dumping investigation leads to a following conclusion: a confirmation of the existence of the chilling effect, induced simply by initiating anti-dumping investigation. The empirical results of this study suggests that the impacts of anti-dumping measures on imports and exports - whether an anti-dumping duty levied on the subject merchandise would cause a decrease in the import volume, and how long the effects would last - depend on numerous country- and industry- specific features. Therefore, it is necessary to propose implications against the United States, China, and India for the efficient operation of Korea’s anti-dumping system, by considering comprehensive analysis of operational issues. The criteria for selecting the vulnerable domestic industries is based upon the anti-dumping investigation frequency, the number of cases terminated by impositions of measures as a percentage of all the cases initiated, the shares of product volume imported (exported), and the growth rate of imports (exports) of products. The proposed country- and industry- specific implications are expected to contribute to developing Korea’s strategy against the use of anti-dumping measures by the United States, China, and India.

Global imbalance has been widening on a large scale from the start of the 21st century and was received notice as a critical risk factor for the future of the world economy. Global imbalance was maintained by the inflow of the dollar from the surplus countries (China) to the deficit countries (U.S). Many economists worried that if profitability and stability of dollar assets became questionable because of decreasing credibility of the U.S economy, the risk of hard landing of the world economy would become a reality through volatile exchange rates and hikes in U.S interest rates. Fortunately, global imbalance was reduced considerably since the year 2007 and therefore the economists had less cause for worry about the possibility of hard landing due to global imbalance.
This study discusses the trend of global imbalance since the 1970’s, focusing on the U.S-Japan imbalance in the 1980’s and the U.S-China imbalance in the 2000’s. Then we analyze the adjustment process of global imbalance and its causes during the last few years. In doing this, we identified three possible causes– the U.S, China and the exchange rate. We find decreases in private consumption and increase in the savings rate in the U.S., increase in state-led investment and increase in consumption due to rising of income in China and also government policies in China. All of these causes result in narrowing of the savings-investment gap in both countries. Appreciation trend of the Yuan against the dollar also helped in reducing the imbalance.
We try to forecast whether the recent trend, the narrowing of global imbalance, will continue over the medium and long term horizon. To do this, we empirically investigate the determinants of the current account employing the national panel data. The results of the empirical study show that it is difficult to judge conclusively the continuity of adjustment of global imbalance, because there exists a mixture of positive and negative elements in the results. Reduction of government deficit of the U.S and more flexible exchange rate policy in China are the key factors that will determine whether the trend will continue.
We also try to draw implications of the adjustment of global imbalance for the structural fine tuning of the world economy. First, the U.S-China currency dispute which was called “the currency war” at the time of G20 of 2010 has been and will be further diminished. The adjustment this time will come not only from exchange rate adjustment but also from increases in U.S savings and China’s consumption, which can result in reduction of the saving-investment gap at the structural level. Second, the macroeconomic structural adjustment of the U.S and Chinese economies; and gradual progress made in the reduction of global imbalance. The U.S. efforts to increase exports, which will require strengthening of the competitiveness of the manufacturing sector, will take considerable period of time because the economy has been heavily dependent on the service industry including the financial sector over the last 30 years. Chinese efforts to rely more on domestic demand will accompany costs such as economic slowdown and workers’ adjustments to new industries. Third, it is necessary for the large surplus countries including Germany and regions like East Asia to participate in the global policy cooperation by increasing their domestic demand and imports, because the adjustment between the U.S and China is not sufficient to maintain and increase the global aggregate demand.

  China is pursuing a regional development strategy for its northeast region with the realization that it is an area imperative to China’s future development and that it will function as a powerful engine in securing China’s regional competitiveness. For the successful development of northeast China, however, the issues related to the Korean peninsula must first be resolved. Therefore, it is important to understand how China views the Korean Peninsula, and which strategy it will employ in approaching this problem.
This study uses the ideal model method and global action patterns method to demonstrate that peaceful unification is the most ideal setting for China regarding the Korean Peninsula if China’s goal is to pursue its development strategy in the Northeast region. We conclude that China will choose a policy strategy that supports the unification of the Korean Peninsula in order to implement its own national strategy.
We consider four main scenarios related to the unification of the Korean Peninsula: status quo, military conflict between South and North Korea, North Korea’s pursuit of openness and reform, and peaceful unification. We conclude that China will strategically construct its policy underpinnings vis-à-vis the Korean Peninsula in support of a peaceful unification. Furthermore, China will eschew strategic competition with neighboring powers such as the US or Japan, and instead embrace cooperative co-existence in Northeast Asia. This would also mean that Northeast Asia will soon emerge on the global center stage as a peaceful and cooperative region.
Unification of the Korea Peninsula and economic benefits for China can be considered in three aspects: unification and economic benefits for China’s northeast region resulting from North Korea’s reform and opening up, the ripple effects of inter-Korean economic integration on China’s Eurasian strategy, and the application of the One Belt and One Road Strategy. If a Northeast Asian triangular trade network becomes a reality, China’s northeast region would be the greatest beneficiary in connection with unification of the Korean Peninsula. In particular, economic effects engendered from increased openness of the three provinces of northeast China due to Korean unification will be considerable. Increased openness of the three northeast Chinese provinces by itself is expected to generate economic benefits of about 283.6 billion RMB.
Additionally, when considering the inter-Korean economic integration using the CGE (Computable General Equilibrium) model, while it is true that trade diversion caused by inter-Korean economic integration may impact China negatively in the short term, North Korean economic growth will accelerate and increase import demand, which may increase China’s exports to North Korea and create a positive ripple effect.
Regarding the Eurasian Strategy and the application of the One Belt and One Road Strategy, if President Park’s Eurasia Initiative Strategy is implemented, China’s Northeastern region would experience increased openness and more areas would become open to development, henceforth strengthening its regional competitiveness. This would mean that the Northeast region could become a new engine of growth for the Chinese economy.
Since the beginning of the modern era, all international environmental factors that crucially impacted China’s national interests have stemmed from the Korean Peninsula. Thus, Korean unification and China’s security interests are closely connected.
In China’s perspective, Korean peninsula also represents an extremely important issue to the US and Japan in implementing their respective strategies. As a result, surrounding powers such as the US, China, Russia, and Japan is paying close attention to the constantly changes and standoff politics of inter-Korean relations; naturally, there would be strategic competition among the surrounding major powers who intend to prevent negative outcomes that could hurt them.
Reconciliation of the two Koreas or unification of the Korean Peninsula will induce the surrounding countries to acknowledge that they could lose out on potential economic benefits if they do not actively participate in Northeast Asian regional cooperation. If so, the mood in Northeast Asia will be extremely cooperative, which would provide favorable international conditions for Chinese regional strategy vis-à-vis East Asia.
Sino-Korean strategic cooperation is absolutely necessary in the process of unifying the Korean Peninsula. In the long-term view, South Korea needs to pursue a neutral policy towards the US and China. In the current situation, China also maintains a favorable attitude regarding the ongoing active role of the US forces stationed in Korea. However, the role of the US-Korea alliance must be limited within the Korean Peninsula. Moreover, while North Korea is undergoing top-down reform, a desirable policy for South Korea and China should be to encourage change in North Korean society and help North Korea to open up and initiate reform.s
Especially, if one wishes to see substantial changes in North Korea, one must actively conduct economic exchange with North Korea. Furthermore, regarding economic exchange with North Korea, South Korea and China should be attentive towards the creation of special zones in North Korea.
Finally, in order to realistically resolve the North Korean nuclear problem, the issue at hand must be divided into several steps. Internal politics within North Korea must first be stabilized by achieving economic exchange within set boundaries and at the same time, we must induce North Korea’s integration into the international society. Unified Korean Peninsula will play the role of a hub, located at the crossing point of interests of great territorial and maritime powers. Of course, the benefit will be shared by neighboring countries, as well as China and the Korean Peninsula. In this way, a peaceful unification of the Korean Peninsula will be a bonanza not only to the Korean Peninsula and China, but also to all neighboring countries.

  A peaceful and market-oriented unification of South and North Korea is likely to give rise to a large investment boom in the unified Korea. An increase in domestic absorption in the unified Korea will also be necessary to achieve rapid economic development in the north and to reduce the huge migration pressure from north to south that would follow unification. This boom in demand is likely to substantially increase GDP and employment in Korea’s trade partners (Japan, the United States, etc.), most of which are currently suffering from a serious lack of demand. To realize this optimistic scenario, Korea and its trade partners need to collaborate to finance the temporary current account deficit Korea will experience after the unification. We examine these issues using a neoclassical growth model, an open macroeconomics perspective, the World Input- Output Database (WIOD), and other statistics.
The economic impact of unification on trade partners will crucially depend on how economic development proceeds in the unified Korea. Many preceding studies on the economic costs of unification, such as Song (2013) and Kang, Lee, Pyun and Hyun (2014), assume a gradual unification. However, if we assume a democratic unification process, it will be difficult to restrict migration (Wolf 1998) and the south will face strong pressure of immigration. To reduce this pressure, the unified Korea will need to try to achieve rapid economic growth in the north through large investment and income transfers. Since the present north-south population ratio is much larger than the east-west population ratio in Germany in 1989 and the present per capita GDP gap between the north and the south is much larger than that in the case of the German re-unification, Korean unification will cause a greater increase in domestic absorption than was observed in Germany.
In our analysis, we assume that the unified Korea will meet the supply shortage implied by the current account deficit through a proportionate increase in goods imports from its trade partners. Using the 2011 WIOD, we analyze the economic impact on Japan, China, the United States, and Russia by sector and by year. We take account of indirect effects (i.e., effects through changes in intermediate inputs). We conduct a standard Leontief-type analysis with the assumption of supply constraints in the unified Korea.
The analysis shows that Korea’s major trade partners will experience a substantial increase in GDP and employment. China will enjoy the largest benefits. If we sum up the increases in Japan’s GDP for the period 2015-25, the total will be US$234.5 billion. Job creation in Japan will be mainly concentrated in the machinery and leasing industries.
Korean unification also means the country’s position as a rival to Japan in the East Asian division of labor will be boosted. Empirical studies show that countries that are neighbors, countries with ethnic ties, and countries with FDI in each other tend to trade more (Felbermayr 2009, Fukao and Okubo 2011). Therefore, after unification, China-Korea trade may increase significantly. We examine how other countries will be affected if they are left behind by the deepening of trading ties between China and Korea. For this analysis, we assume that the total amount of Korea’s exports to China doubles for each good and service, but that China’s total imports of each good and service do not change. This means that other countries are crowded out by Korea from the Chinese market. Similarly, we assume that the total amount of China’s exports to Korea doubles for each good and service, but that Korea’s total imports of each good and service do not change. This means that other countries are crowded out by China from the Korean market. To focus on the crowding out effect, in this analysis we assume that Korea has sufficient production capacity to increase exports to China.
This analysis shows that the deepening of trading ties between China and Korea will have a larger negative impact on Japan than on the United States. The reason is that Korea, China, and Japan specialize in similar products. Job losses in Japan will be concentrated in a small number of sectors such as electrical and optical equipment, basic metals and fabricated metal, and leasing.
Infrastructure development is a necessary engine for regional development, and government should play an important role in such development and financing infrastructure projects. According to our simulation in the previous section, however, the domestic savings in Unified Korea are insufficient to finance this massive infrastructure investment. Therefore, Unified Korea should seek a way to procure the necessary funds from abroad.
Vast domestic savings in China and Japan should play a key role for financing North Korean infrastructure projects. Current availability of economic and social infrastructure in North Korea is highly limited. For example, the amount of electricity generated in North Korea in 2012 was only 5 % of that in South Korea. According to our estimation, the North Korea region will need to invest on average 2.9 billion US dollars per year between 2015 and 2025. Both the Japanese and Chinese governments hold a large amount of foreign currency reserves, and they might consider utilizing some portion of their reserves for investments to the North Korea region’s infrastructure funds. The funds would also be able to provide the guarantee against political, economic, and financial risks associated with the projects.
Japanese private firms may consider that participation in the Unified Korean infrastructure projects is a big business opportunity if the associated risk for the business is reduced by the international fund institution’s guarantee. Japanese firms continue to keep the international competitiveness in the participation in the overseas energy related infrastructure investment projects, especially power generation construction and managements.

 

I. Introduction                                                                           

II. Stages or Degrees of Integration

III. General Equilibrium Calibration of Unification
1. Constraints on International Trade                                       ·
2. Technical Change                                               
3. The  "Obsolescence Shock"                                                      
4. Military Demobilization                                                         
5. Integration Scenarios                                                 

IV. Implications for the United States from the Gravity Model

V. Policy Issues
1. US Economic Diplomacy toward North Korea: The Trade Dimension
2. US Economic Diplomacy toward North Korea: The Financial Dimension           
3. US Policy  under Alternative Unification Scenarios 
4. The  Peace Dividend
5. US Contributions to Financing Unification

VI. Conclusion

References

The United States has a strong economic and political interest in seeing the Korea unified as a democratic capitalist state. The specifics of US interests and involvement in unification are partly contingent on scenario: excluding the horrific possibility of war, the main two scenarios come down to a protracted, consensual process in which North Korea maintains sovereignty for a significant transitional period and an abrupt collapse and absorption scenario along the lines of the German experience. In contrast to the fundamentally benign German experience, one variant on the collapse and absorption scenario could involve an extended period of violent political opposition to South Korean rulefollowing state collapse. This might involve a quarantine, or resemble the situation that has developed between Israel and Palestine, and would impede economic revitalization and dampen the benefits documented in this paper.
Which of these two basic scenarios―prolonged consensual unification or abrupt collapse and absorption― prevails revolves around whether North Korea successfully addresses its economic, political, and diplomatic challenges and survives permanently as an independent political entity, or whether the multiple stresses that the regime confronts prove unmanageable and it experiences abrupt change, culminating in its absorption by South Korea. Ultimately the key determinant is the capacities of the North Korean leadership. While the rest of the world can influence incentives at the margin, we should not exaggerate how much influence we have on these internal developments.From the standpoint of US policy the distinction between these alternative scenarios is critical, however. 
This paper begins by reviewing some general equilibrium model (CGE) results for Korean unification which are used to benchmark the magnitude of the “unification shock.” This work is complemented by gravity modeling of bilateral merchandise trade. The modeling work presented in this paper indicates that the thoroughness and rapidity of economic reform in the North matters noticeably in the calculation of the economic impacts on the US. The more traumatic collapse scenario followed by successful rehabilitation of the economy in the northern part of the peninsula generates a larger impact on the US. In such a scenario, conservatively estimated, US merchandise trade with North Korea might expand from virtually nothing to approximately $1 billion, with a possible additional $300-425 million in services trade.  The actual expansion of two-way trade could be much higher: if North Korea simply exhibited the same propensity to trade with the US as does South Korea, a decade after unification bilateral trade could be as high as $20 billion.
The goods trade would likely consist mainly of North Korean exports of light manufactures in return for American capital goods and agricultural products. Other products of North Korea such as metals used in the electronics industry would be imported by the assembly operations of US firms outside the US, and might be considered “indirect” exports to the US. The US would export business and professional services to North Korea and import travel and tourism services.  US firms would also invest in North Korea, but under a protracted, consensual unification scenario, labor standards issues could pose a constraint.
Similarly, US economic interaction with North Korea is constrained by a dense web of sanctions and other measures, some in the form of Congressional legislation, others in the form of Executive orders that discourage economic integration between the two countries. In a consensual unification scenario, these sanctions will impede economic integration between the US and North Korea. There is no guarantee that either the President or the Congress will act even if relations improve between North and South Korea.  The removal of these constraints would actually be easier in a collapse and absorption scenario in which the North Korean state would disappear, rendering most if not all of these measures moot, and economic exchange would occur on the basis of the relatively liberal set of rules and practices observed between South Korea and the US. A modest peace dividend, perhaps boosting bilateral trade by $50 million, could obtain under this scenario.
Under either scenario, the binational commission created in Annex 22-B of the KORUS agreement could be used to rapidly liberalize trade if circumstances warranted. Depending on scenario and sequencing treatment of the northern part of the peninsula under agreements such as the Trans-Pacific Partnership (TPP) could be either relatively straightforward or problematic.
Unification is likely to be very expensive. There is a role for the US public to play both bilaterally and through the international financial institutions (IFIs). The capacity of the US government to contribute directly will be partly a function of its own fiscal situation which is highly uncertain. But contributions to unification finance should not be thought of strictly as a public sector activity. The private sector will have a critical role to play as well. Indeed, the ultimate economic contribution of the US to Korean unification is likely to come through the private sector; foreign direct investment constitutes the institutional mechanism for both technology transfer and the links to marketing and distribution networks globally that North Korea currently lacks. Aid should seek to complement and encourage such private flows,not provide a substitute for them.