Formal vs Informal institutions: Case of Trade between North Korea and China

This is a fascinating paper by the trio — Stephan Haggard, Jennifer Lee, and Marcus Noland.

The role of institutions in growth and development is debated on many aspects. One such aspect is the role of informal institutions in growth. SOme economists have shown how commerce prospered in earlier times in absence of formal institutions. They are inefficient but still get the work done:

History provides fascinating examples of traders who managed to organize institutions to support exchange in the absence of state protection of property rights and contracting, even over long distances (Milgrom, North and Weingast 1990; Greif 1993; Greif, Milgrom, and Weingast 1994; Clay 1997a, b). Such examples are not limited to the past, the development and comparative economics literature yields a number of contemporary examples, from trans-African trade (Kennedy 1988) to the emergence of contracting and informal dispute settlement mechanisms in transitional economies such as Vietnam (McMillan and Woodruff 1999a, b). Yet the informal institutions required to support an efficient level of trade are also demanding. Merchants must be able to act collectively both to protect themselves and to impel the sovereign to abjure expropriation, to the ultimate benefit of both the traders and the sovereign.

This paper reviews this role of informal institutions debate in a natural experiment setting – trade between North Korea and China. Few Chinese trade with North Korea and there is no real formal institutions to govern the trade.

Economic integration between China and North Korea represents a remarkable natural experiment for exploring these issues. Traditionally, trade between the two centrally planned economies was determined politically and was relatively small. 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 government and party offices, even military units—to engage in entrepreneurial behavior to secure food. One aspect of this coping behavior was the development of decentralized cross-border barter trade for food. This barter was eventually monetized and spread to a much broader array of both goods and actors. This “marketization from below” led to a dramatic expansion in bilateral trade (figure 1), but in a cross-border setting characterized by the apparent absence of  conventional property rights protections, formal dispute adjudication mechanisms, even a published tariff schedule—in short, all of the institutions deemed necessary for efficient exchange

However, because of lack of formal institutions, the nature of Chinese firms trading is different. Plus they always complain and are wary of ever-changing regulations in North Korea. As a result Chinese firms are smaller in size and limit them to trading firms with not much manufacturing. Chinese are also not happy with the current system and would prefer more formal systems:

There are basically two sorts of Chinese enterprises doing business in North Korea: large stateowned enterprises with long-standing relationships with their North Korean counterparts, and a larger number of small, essentially private businesses (regardless of their specific legal status in China) that restrict themselves primarily to trading activities. The majority of firms in our survey—nearly 90 percent—report being able to make a profit in North Korea. Moreover, their assessments of the future atthe time of the survey  were generally positive; most respondents indicated that they regarded the trend toward liberalization as irreversible.

Nonetheless, Chinese appraisals of the North Korean business environment are generally negative and manifest fear of expropriation of investments made in North Korea. A large majority of the respondents complain about infrastructure issues— most notably the historic ban on cell phone use which is beginning to ease—but respondents also complain about the nature of the regulatory environment, the risk of arbitrary changes in rules and practices and lack of reliable dispute adjudication. As a result, Chinese enterprises limit their exposure by generally choosing trading over investing, conducting transactions in China, holding their North Korean counterparts to tight settlement terms, and demanding payment primarily in US dollars or Chinese yuan.

So, the lesson is informal instis work only for a limited scale. Firms need proper systems to grow:

In sum, institutional weakness deters integration, deters investment relative to trade, and inhibits normal trade finance. Given the weakness of formal institutions and the corresponding limits on the risks Chinese firms are willing to take, the rapid growth in exchange that we have seen in recent years may prove self-limiting if the effectiveness of informal institutions erodes. Institutional improvement would clearly have significant welfare implications, affecting the volume, composition, and financial terms of cross-border exchange.

The paper is based on a survey of 300 firms based in Jilin and Liaoning Provinces of China which do business with North Korea. The authors also compare this sample with 53 firms based in the same provinces which do not trade with North Korea.

Barring this it gives you some nice insights into North Korea’s economy, of which very little is known. Both Stephan Haggard, and Marcus Noland have written number of papers on North Korea. See the reference list for more stuff.

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