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Abstract
Theory tells us that weak rule of law and institutions deter cross-border integration, deter investment relative to trade and inhibit trade finance. Drawing on a survey of more than 300 Chinese enterprises that are doing or have done business in North Korea, we consider how informal institutions have addressed these problems in a setting in which rule of law and institutions are particularly weak. Given the apparent reliance on hedging strategies, the rapid growth in exchange witnessed in recent years may prove self-limiting, as the effectiveness of informal institutions erode and the risk premium rises. Institutional improvement could have significant welfare implications, affecting the volume, composition and financial terms of cross-border exchange.
This paper is based on an unprecedented survey of more than 300 Chinese enterprises that are doing
or have done business in North Korea. The results provide some insight both into how firms manage the risks associated with weak institutions and the particular constraints such weaknesses place on bilateral trade and investment. On the one hand, Chinese firms are adopting contracts and trading mechanisms that are self-enforcing, i.e., do not require third-party government enforcement. On the other hand, we document that these strategies have costs, visible in the scale and nature of firm operations and other crucial elements of exchange such as the willingness to extend credit. There are basically two sorts of Chinese enterprises doing business in North Korea: large state owned 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 at the 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.
Bribery and corruption are pervasive features of the business environment, and might be seen as a rational response to the lack of property rights protection. If bribe payments result in credible provision
of protection, they are one political mechanism for assuring trade and investment. However, there is some evidence that firms face a greater likelihood of economic predation as their size increases. The limited scale of Chinese operations and the reluctance of firms to invest or even to engage in anything more than spot market transactions appears to stem directly from the absence of property rights protection and pervasive corruption. In the absence of formal institutions for dispute settlement, there is some evidence that Chinese businesses may seek to protect themselves from official predation via informal networks of other firms. Recourse to other firms rather than either North Korean or Chinese authorities may constitute an example of how private traders can use reputational mechanisms to protect themselves. But it is again important to emphasize the suboptimal nature of these arrangements; most firms that have had disputes with their counterparties report a low level of satisfaction with the outcome. 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.
Who Are the Participants?
The results reported here are derived from a survey of 303 enterprises conducted in October and November 2007. All the firms in the survey operated in the Chinese provinces of Jilin and Liaoning, although they were not necessarily headquartered there. (Details of the survey implementation are provided in the appendix.) Two hundred and fifty of the firms (82 percent) were engaged in trade or investment with North Korea at the time of the survey. As there are no public business registries listing firms engaged in business with North Korea, the firms necessarily constitute a sample of convenience, culled from a variety of sources. However, extensive interviews suggest that the sample is broadly representative of the cross-border business. These firms are engaged in importing, exporting, investment and the permutations and combinations of these three activities (figure 2). Nonetheless, pure exporters make up the largest group. Most are relatively small private enterprises (figure 3), and most have initiated cross-border exchange with North Korea since 2000 (figure 4). However there is a distinct minority of a dozen large state owned enterprises (SOEs), some of which have been doing business with North Korea for more than a quarter-century.
We also surveyed a control group of 53 firms drawn randomly from firms operating in the two provinces which were not doing business in North Korea at the time of the survey; 43 (14 percent) had never engaged in cross-border exchange with North Korea, and a small share (10 firms, or 3 percent of the total sample) had previously engaged in trade or investment but had withdrawn. There are a number of salient differences between the firms that are not doing business in North Korea and those that are starting with size. Of those doing business in North Korea, 55 percent have 1-10 employees and 91 have 100 or less. The point is even clearer if we focus on revenue: 28 percent of firms doing business in North Korea had sales revenues of less than 100,000 renminbi, around $12,000. Most of the firms doing business with North Korea are clearly small entities. By contrast, 42 percent of the firms not doing business in North Korea had more than 100 employees. Six—11 percent of the sample of 53—have more than 1000 employees and 13—nearly a quarter of them—report sales revenues of more than 50 million renminbi, about $6 million.
Ownership patterns also vary. Fifty-eight percent of the firms doing business in North Korea are private enterprises, and another 14 percent are sole proprietorships; only 3 percent are foreign. By contrast, the not-doing-business sample includes a different mix of ownership structures, with 38 percent foreign firms and only 28 percent accounted for by private enterprises and sole proprietorships. Interestingly, there were not many SOEs in either sample (5 percent in the “doing business” sample, 4 percent in the “not doing business” sample) although joint stock companies—which frequently have government participation--accounted for about 21 percent of the first group and 26 percent of the second group. Core activities also vary. Fully 54 percent of the firms doing business in the DPRK report that they are involved principally in trading; another 5 percent identify themselves as diversified groups that have trading operations. By contrast, only 26 percent of the firms not doing business in North Korea are trading companies, with a much higher representation of firms involved in manufacturing (49 percent of those not doing business as opposed to only 8 percent of those doing business).
Among the other activities represented by the firms doing business in North Korea are—in descending order—construction(16 percent), services (10 percent), and agriculture (6 percent). The traders were asked about the most important product that they exchanged with their largest customer or supplier. The findings comport broadly with what we know about bilateral trade at the time of the survey from aggregate trade data. For exporters, the major products included construction materials (including upholstery; 13 percent), apparel and clothing (11 percent), grain and edible oils (10 percent), and chemicals and electrical equipment (8 percent each). On the import side, the product mix is much more concentrated, with aquatic products accounting for nearly 30 percent of major products from major suppliers, with metal and metal products (27 percent) and wood and wood products (18 percent) accounting for significant shares; indeed, these three product categories together account for almost 75 percent of the top imports from the dominant supplier. Among investors, the most frequently cited motivations are to expand business in the domestic market (29 percent), to sell there (21 percent), or to exploit natural resources (27 percent). Only 23 percent are locating in North Korea as an export platform, either back to China (13 percent) or to third markets (10 percent). We interpret these results to reflect in part weak infrastructure, but also prevailing policies and incentives that limit opportunities for export-oriented investment.
The vast majority of the enterprises in the sample doing business in North Korea are Chinese (98 percent), though around 20 percent of the control group report being headquartered outside of China, mostly in Japan or South Korea. Forty percent of the respondents report that their chief executive officer(CEO) can speak Korean. This share is virtually identical across both the firms currently doing business in North Korea and those which are not. While our understanding of the Chinese participants is relatively complete, our understanding of their North Korea counterparts is much weaker. Figure 5 reports the Chinese firms’ responses to a question about the legal status of their primary North Korean counterparty, broken down by importers, exporters, and investors. In all three cases, the majority of respondents report that SOEs are their main counterparties, although this may well encompass entities of very different sorts.3 Nonetheless, interesting differences emerge. Pure exporters report a wider array of North Korean counterparties, including Chinese brokers, private firms and individual entrepreneurs. These actors have played an important role in making emerging markets in North Korea for imported consumer goods and even intermediates. Importers, and particularly investors, report a much greater dependence on official entities: SOEs, government bureaus and the military.
Subjective Assessments of the North Korean Business Environment
The Chinese firms surveyed generally have a negative assessment of the business environment in North Korea. Among the firms not doing business in North Korea at the time of the survey, by far the most frequently cited reason was lack of familiarity with the North Korean market (87 percent agree or strongly agree). Fifty-five percent cite lack of familiarity with the country more generally and 57 percent cited the weakness of the North Korean economy. However, just over half (51 percent) cited the poor reputation of DPRK policies and 45 percent cited the poor reputation of North Korean firms. Among those doing business in North Korea, almost 88 percent report that they are able to make a profit. Is this success a political artifact of Chinese government support for trade and investment with the DPRK? In fact, few businesses (and none of the SOEs, surprisingly) report any support from the Chinese government for their activities. Seven percent of the respondents indicated that they received special tariff reductions or exemptions, presumably under Chinese provisions for preferences for local firms engaged. The category “SOE” encompasses entities and economic behaviors of at least three different types. The first are SOEs engaged in their traditional, legally sanctioned lines of business. The second are SOE’s whose managers have exploited the company’s legal status and resources to initiate non-traditional and in some cases completely unrelated (and even illicit) lines of business. Third, entrepreneurs affiliate with SOE’s for political protection (Haggard and Noland 2007); the “SOE”
may in fact be a shell for an effective joint venture partnership. Similar uncertainty about the true nature of the enterprise exists for other types of counterparties that are reported in the survey such as North Korean government offices. Indeed, it is possible that the Chinese firm itself does not even know the true “inside story” regarding its North Korean counterparty. in small magnitude “border trade.” A handful of firms report receiving trade insurance, investment guarantees, or preferential finance. But government support, narrowly construed, does not appear to play a significant role in enabling exchange.
Respondents do see some positives in the operating environment. Among the firms doing business in the country, a slight majority believe that it is getting easier to do business in North Korea.4 About 50 percent cite the reduction in trade barriers and the emergence of general markets as positive features
in the operating environment. It is possible that at the time of the survey, the business environment was improving because of progress on the nuclear issue during 2007 and the announcement and staging of a second North-South summit just prior to the survey. It may also be the case that learning takes place: agreement with the statement that North Korean regulations make it hard to do business is negatively correlated (at the 10 percent level) with length of involvement with North Korea.
However, we also asked the firms doing business in North Korea a series of ten questions about the factors that impede their business (figure 6). Most firms report problems with infrastructure; large majorities indentify the ban on cell phones (86 percent) and inadequate infrastructure (79 percent) as constraints. However, regulation is also a major hindrance, with 79 percent citing changing regulations, 70 percent citing the nature of regulations, and just over 60 percent reporting that it is impossible to do business outside the special economic zones and that there is expropriation risk. We can assess the effects of these perceptions on entry by comparing the attitudes of those doing business in North Korea with those not doing business there, using simple t-tests. Perceptions on some issues do not exhibit significant differences between the two sets of firms; firms of both sorts have similarly negative assessments along these dimensions. For example, perceptions of the quality of infrastructure and barriers posed by weak telecommunications do not show significant differences.
However, there are statistically significant differences in their views of North Korea’s institutional environment. Firms not doing business are more likely to report that the depreciating currency poses a barrier to their business(at the 1 percent level), but are also more likely to see high taxes and the regulatory environment (at the1 percent level) and the perceived difficulty of doing any business outside the special economic zone (at 5percent level) as barriers. Perceptions of a problematic business environment potentially deter entry. The trading firms doing business in North Korea are more likely to agree (at the 5 percent level) with the statement that is it too risky to invest because of potential expropriation, suggesting that such fears push firms away from investment and toward trading modalities. Likewise compared to those not doing business, investors complain even more frequently (at the 5 percent level) than traders about high taxes (at the 10 percent level), which could be interpreted broadly as a proxy for government-related costs of doing business.
Corruption, Dispute Resolution, and Settlement Terms
The survey provides evidence of the business environment in North Korea that goes beyond subjective assessments to corruption, the weakness of dispute resolution and the effects of the environment on the terms of financial settlement. The findings on corruption are consistent with evidence from refugee surveys, including testimonies of former state and party officials, of high—and possibly rising—levels of corruption in North Korea, (Haggard and Noland 2010b, Kim 2010). Most of the Chinese firms report that they are required to get permission or approval from some level of the North Korean government to do business in North Korea, though there are differences across types of firms. All of the Chinese SOEs report having obtained permission before starting a business, but 29 percent of the private businesses report that they did not obtain any permission or approval by the North Korean government. Only 9 percent of investors—six firms—report that they have no need of government approval. By contrast 29 percent of traders and 47 percent of those who are engaged only in exports to North Korea report that they have no need of government approval to operate.
A majority of the firms in our survey report a need to bribe to do business (55 percent). However, investors are much more likely to report a need to bribe (73 percent) than traders (54 percent) or those engaged in exporting only (44 percent); these differences between investors, traders and exporters are significant at the 1 percent level. We also asked about actual bribe costs, and the differences between investors and traders are once again clear. Nineteen percent of the firms report spending more than 10 percent of revenues on bribes, but more than half of investors (53 percent) report spending more than 10 percent of annual revenues on bribes. These differences presumably reflect the greater complexity of entering as an investor, the more extensive contact with local officials, and the greater risk of expropriation.
A critical feature of the institutional environment is the capacity of investors and traders to resolve disputes. The survey permitted respondents engaged in multiple types of business to characterize each of 7. This pattern of response appears to be borne out of experience. The responses are similar for the quitters; they do not appear to have distinctly harsh views of North Korea. Among the firms that had never done business in North Korea, most were uncertain about the need to bribe to do business; 37 percent thought that bribery was necessary and 12 percent did not. The firms never having done business in North Korea had lower perceptions of the incidence of bribery at the 5 percent level of statistical significance, their principal business relationships separately, for example, allowing a single firm to report on relations with its main import, export, and investment partner.
Disputes appear to be fairly common. Twenty-one percent of these relationships had generated disputes. The pattern of disputes was fairly uniform across types of business relationships: exporters (19percent), importers (24 percent), and investors (23 percent). But if we compare investors with those who export only, we once again see evidence of the hold-up problem. Fully 41 percent of investors report disputes, while only 4 percent of exporters do. Weak dispute settlement appears to push firms back to less risky, “cash and carry” transactions. When asked how they would resolve a dispute, the pattern of responses across exporters, importers and investors differed in predictable but interesting ways; we focus here on the differences between exporters and investors. More than one-quarter of exporters indicated that there were no third parties from which they could seek help. To the extent that they did believe there was recourse, it was entirely on the Chinese side of the border: Twenty percent indicated that they would seek help from Chinese government officials, 19 percent would look to other Chinese companies or business associations, and 17 percent would use the Chinese court system.
Although the number of disputes reported on the part of pure exporters was small (only 5 of 113 pure exporters), their pessimism was warranted; none of the five reported they were satisfied with the process of dispute resolution. For the investors, more than one-third would try to settle matters privately (35 percent), 31 percent would appeal to North Korean local officials, and 22 percent to Chinese officials, presumably reflecting the far greater importance of North Korean officials in settling investment disputes that involve the foreign investor’s physical presence in North Korea. It is also notable that the share reporting that they would appeal to local officials (31 percent) exceeded that of provincial officials (16 percent) and central government officials (12 percent). This pattern is consistent with a reduction in de facto central control that was a byproduct of “marketization from below,” but it may also reflect the fact that investors see local officials as more forthcoming. Whatever the investors thought ex ante, their disaffection after the fact is high; 77 percent report that they were not satisfied with the way their dispute was settled (and recall that the share of investors reporting disputes was also much higher than firms involved in export only). When asked about how they would settle disputes in the future, respondents suggest that local and provincial officials may be more willing to protect property rights than their higher ups. Investors who experienced disputes showed a greater proclivity to pursue resolution of future disputes through appeals to local officials (32 percent v. 19 percent) and provincial officials (25 percent v. 7 percent).
Settlement terms also provide insight into the credibility of the operating environment. None of the traders report doing any business in North Korean won. While this might reflect simple exchange rate risks, a long history of currency revaluations—culminating in the conversion of December 2009— suggests that the risk is also political. Most Chinese exporters to North Korea use Chinese yuan as the settlement currency (55 percent), possibly reflecting the preference of small traders to be paid in local currency, followed by US dollars (34 percent), and barter (8 percent). Imports, by contrast, are settled primarily in US dollars (52 percent), followed by Chinese yuan (29 percent), and barter (15 percent). The more frequent use of US dollars in the import trade may reflect the preferences of sellers who want to get paid in home or conveniently usable currencies; it could also reflect the distinctive preferences of North Korean SOEs (more highly represented among Chinese importers’ counterparties) and/or the North Korean government which may desire to earn convertible currency that does not have to be spent in China.
Finally, settlement terms are typically very tight, reflecting lack of trust and credit. Less than 5 percent of the traders report extending credit to their suppliers. Most trade is settled at time of delivery; the next most frequently occurring moment of payment is at time of order placement. Less than 10 percent of import and 5 percent of export transactions occur more than 30 days after delivery. Particularly given dissatisfaction with dispute settlement, it is not difficult to understand why credit is limited.
En try, Exit, and Modality
What distinguishes enterprises that enter the market from those that do not? Among those that enter, what determines who subsequently leaves? A related question is what drives choices regarding different types of business activity: whether firms choose to export and import only, or to invest or engage in some more complex combination of business activities. Investing clearly involves much more substantial hold-up risk, as it does in a market economy as well. We would therefore expect the property rights, contracting and regulatory environment to matter more to investing firms. Probit regressions estimated on entry are summarized in table 1. Ownership type and size matter. As shown in specification 1.1, private ownership is positively associated with entry, and size, as measured by number of employees, is negatively associated with entry. This relationship is specified slightly differently in specification 1.2 with a similar result: firms choosing to engage in business with North Korea are smaller and more likely to be private than their counterparts. With respect to business activity, service providers are deterred from entry. This could be because of North Korean regulations that create explicit entry barriers, but it could also be because service activities require a local presence which is more risky than arms-length trade transactions.
Also of interest is what does not appear to matter. Variables relating to enterprises’ sources of funding were statistically uncorrelated with entry. In regressions not reported in the interests of brevity, neither
provincial location of the firms’ headquarters nor having a headquarters in a border town are statistically significant. Nor is having a chief executive officer (CEO) who speaks Korean. These characteristics—proximity and language skills—might be associated with being more informed about the North Korean business environment or the ability to make more nuanced risk assessments, yet they neither incline firms toward or away from doing business. We would like to know how ex ante appraisals of the North Korean business environment affect the likelihood of entry, but we face a specification problem in teasing this out of our survey data. The 260 enterprises with current or past experience in North Korea have appraisals that are informed by experience ex post. Econometrically, the values of these regressors may not be predetermined, violating the classical assumption of the independence of the error term and rendering the coefficient estimates inconsistent.
With this caveat acknowledged, specification search suggested that there were three of these variables correlated with entry: views regarding the falling value of the North Korean currency and high taxes(negatively) and ability to make a profit (positively). As shown in table 1, there is some evidence that the responses on taxes and profitability are correlated with entry holding firm characteristics constant. Enterprises that believe that taxes are too high are deterred from entry and those expecting to make profits enter. If we were able to observe true ex ante assessments of the business environment, the list could well be longer. One particular null finding deserves mention. The perception or knowledge of the necessity for bribery to do business with North Korea was uncorrelated with entry. Approximately 70 percent of both firms that entered and did not enter North Korea believed that bribery was necessary to do business in the country; this information did not constitute a deterrent. As we will see below, however, there is evidence that the respondents’ ex ante assessments may have underestimated the actual extent of corruption in North Korea. We are not only interested in whether these enterprises enter the North Korean market but how they do so. There are seven modality combinations (export only, export and invest, export and import, etc.) and our sample contains some enterprises in each cell. In principle we could model this as an unordered polychotomous response model (and indeed tried) but the limited numbers of observations in some cells make this effectively impossible in practice. Instead, we have adopted the more tractable approach of analyzing the decision to invest, conditional on the decision to enter (table 2).
The results confirm the observation from the descriptive statistics of a peculiar distribution of quite different types of entrants. On the one hand, larger firms—as measured either by sales or employment (2.1)—are more likely to invest, but so are firms in the small, private category (2.2). Specification search suggested that the unavailability of outside funds was negatively associated with a decision to invest, though the statistical significance of this relationship is not borne out in specifications 2.1 and 2.2. Having a Korean-speaking CEO is uncorrelated with investing (as it was with entry). But having a headquarters in a border town is actually negatively correlated with investing once firm characteristics are taken into account. If we take proximity as a proxy for information, knowing more about North Korea appears to deter investment. We noted with respect to entry that knowledge of the necessity to bribe was not a deterrent. By contrast, expectations of the need to bribe were positively correlated with investing (though the relationship is statistically insignificant in the table 2 regressions). For the reasons of simultaneity outlined above, these results should not be given a causal interpretation (i.e., bribery does not lead to more investment). Nonetheless, the results are intriguing.
They suggest that firms which have invested in local operations and developed a more extensive understanding of the North Korean economy have a more keen appreciation of the ubiquity of corruption (and the inadequacy of infrastructure) than their presumably less well-informed peers. Finally, we added four variables relating to expectations about dispute resolution. Does the perceived ability to resolve disputes through different channels influence the decision to invest? We aggregated the 12 possible modalities for dispute resolution into four key types: informal North Korean resolution through direct appeals to North Korean officials; formal North Korean resolution through the courts; official Chinese resolution, including through both the courts and political appeals; and informal resolution through Chinese third party networks such as industry associations. The coefficients are relative to an omitted category that is defined by completely private informal dispute resolution such as direct bilateral negotiation.
The results reported in table 2 are quite interesting. The expectation that one could appeal to North Korean officials for dispute resolution is positively associated with investing. Citing formal adjudication through the courts has no impact. Likewise, the expected availability of Chinese dispute resolution mechanisms, while possibly valuable in the case of trade, have no impact on the decision to invest; this makes sense given that Chinese officials are likely to have influence over investments in North Korea only where they are very large and engage the political leadership directly. Finally, the expectation of having to rely on informal Chinese third party mechanisms is negatively associated with actually investing. Whatever benefits these networks may have, they are—probably rightly—not seen as providing recourse in investment disputes. In the interests of completeness, in table 3 we report results on exit. Statistically this is quite challenging insofar as we have only 10 firms in the data set that quit North Korea.
Manufacturing firms are more likely to have quit the North Korean market after entering. If one controls for size, SOEs are more likely to quit, but this result is fragile. In sum, investment is done by larger firms, possibly with external finance although this finding is not robust. Potential investors who believe that they can make direct appeals to North Korean officials to resolve disputes are more likely to commit. Belief in the ability of Chinese authorities to come to the support of firms facing disputes has no effect on investment. Although China-North Korea trade is often treated as highly political, the firms that have invested appear to recognize that they are on their own. They have possibly learned that the infrastructure is even worse than expected and the need to engage in bribery even greater. But they appear to have accepted the latter as it is an integral part of the operating environment, believing that the benefits of bribery in terms of securing political connections and support outweigh its financial costs.
Regulation and Corruption
Once firms enter and invest, the operating environment is adversely affected by both macroeconomic policy (the depreciation of the exchange rate; perceived tax rates) and the inadequacy of physical infrastructure. But some of the problems firms face clearly relate to the nature of the regulatory environment, arbitrary and capricious changes in policy and the consequent need to bribe public officials in order to conduct business. What firms are most adversely affected by these constraints and what are their strategies for dealing with them? Table 4 reports regressions on a question about whether regulations make it hard to conduct business in North Korea; 70 percent of the surveyed enterprises agreed or strongly agreed with this statement. The results are reported in two forms. In specifications 4.1 and 4.2, the dependent variable is a binary variable taking the value 1 if the respondent agreed or strongly agreed with the statement that regulations were a problem. In specifications 4.3 and 4.4, the values of the dependent variable run from 1 (totally disagree) to 4 (totally agree) and the regressions are estimated using an ordered probit estimator.
In both cases, a positive coefficient is associated with greater sensitivity to regulatory obstacles. Many of the results with respect to firm characteristics are subtle and possibly not robust. Even so, they suggest that despite the fact that small firms are more likely to enter, and despite the fact that they engage in activities that reduce risk, such as focusing solely on exports and avoiding contact with officials, they are nonetheless more likely to find the regulatory environment a problem. Small, private firms appear particularly sensitive (4.2, 4.4); medium-sized firms (measured by sales) appear advantaged relative to small firms (4.1, 4.3). SOEs appear relatively untroubled (4.1), which may reflect size or the ability of such firms to draw on their political connections in order to operate.
One apparently robust result is that enterprises that have expected to be able to avail themselves to Chinese dispute settlement mechanisms appear disillusioned. There is evidence in specifications 4.1 and 4.2, that firms with the expectation of using the North Korean court system have relatively positive assessments of the business environment, though this result does not hold up in the ordered probit specifications. It is not clear whether these expectations are informed by experience. A second cut at this issue can be taken by examining the determinants of responses to a question about whether fears of expropriation make it too risky to invest (table 5). We again obtain the result that small or small private firms are more likely to agree, fearing predation. There is some evidence that firms that expect to need to engage in bribery are uniquely concerned about expropriation, as are enterprises headquartered in border towns, suggesting that such fear may be borne of knowledge. As in the previous results regarding investment, enterprises expecting to rely on Chinese authorities for dispute resolution appear to understand that such channels will be ineffective once in North Korea and are apprehensive of expropriation, while firms that believe that they can rely on North Korean political connections are less concerned about expropriation risk.
A pervasive response to the weakness of the property right regime is to engage in bribery. Regressions on the propensity to bribe are reported in table 6. Again, they are reported as both simple and polychotomous ordered probits. We find that firms engaged in trading, which involves the least exposure to North Korea and indeed can be conducted within China, feel less compulsion to bribe. But there is also some evidence that despite the fact that smaller firms have more adverse views of the business environment and are more likely to fear expropriation, larger firms perceive a greater need to bribe; this is evidenced by the statistical significance of three of the four employment dummy variables in specifications 6.1 and 6.3, and the statistically significant negative coefficient on the small, private firm status in 6.2. One interpretation of this result is that the North Korean state is predatory and larger firms make more attractive targets and thus face more substantial hold-up problems. Once an operation reaches a certain size, North Korean officials begin to prey upon it. This is consistent with other evidence of economically predatory behavior by the state apparatus (Haggard and Noland 2011). In the extreme, the size of operations could well be endogenous to predation; the small size of firms doing business with North Korea, as well as the nature of their operations, is a result of the constraints placed on firm growth by the prospects of bribery.
Again, perceptions of recourse to dispute settlement are interesting. Enterprises that believe that they can appeal to either Chinese or North Korean official institutions to manage disputes show no less likelihood to believe in the necessity of bribery to conduct business. The one apparently robust result is that that those firms that believe they have recourse to informal Chinese third-party dispute settlement are less likely to report a need to bribe to conduct business. One interpretation is that if a firm is embedded in an informal network, the association or network may deter predation. Such networks may act like a reputational mechanism that raises the costs to North Korean officials of extorting individual firms.
Conclusion
This paper has used an unprecedented survey of Chinese businesses operating in North Korea to explore the nature of growing cross-border ties in a setting characterized by weak institutions and property rights protections in particular. The Chinese enterprises generally have negative appraisals of the North Korean business environment, with large majorities invoking not only the inadequacy of the physical infrastructure but the problematic nature of the regulatory environment. In response these firms have adopted various strategies to reduce risk, including limiting their activity to trading and to exporting in particular; these transactions involve less exposure to North Korea and can even be undertaken in China. Such strategies are particularly prevalent among small and small private enterprises and firms that do not believe that they can call upon political connections in North Korea.
Transactions are undertaken in ways that suggest limited trust, including not only settlement in hard currencies but very stringent payment terms and limited credit, in effect “cash-and-carry.” Bribery and corruption are common. There is some evidence that the likelihood of predation is correlated with size, which could add a self-limiting aspect to the expansion of cross-border integration. Firms may limit the scale of involvement in order to fly beneath the radar of a predatory state. The survey indicates that Chinese firms receive little support from the government, and have a limited belief in the ability of their government to protect them in the face of disputes. In the absence of formal institutions, there is some evidence that Chinese businesses may seek to protect themselves from predation via informal networks capable of imposing reputational penalties on North Korean actors.
As cross-border integration proceeds, presumably so does the number of participants and the effective degree of anonymity. Such a development could erode the effectiveness of reputation-based sanctions. Unless the increased density of participants strongly promotes the formation of voluntary associations (or induces the state to intervene) the ability of the network to identify and sanction those who violate contracts may not keep pace with the rise of anonymity. This raises the possibility of another self-limiting aspect of the growth of cross-border exchange, as the risk premium on doing business in North Korea rises unless offset by a concomitant strengthening of formal or informal institutions. There are clearly gains to be had from stronger institutions in North Korea, not only in the volume of trade and investment but in an expansion of its scope beyond smaller traders and connected SOE’s. Intriguing in this context is recent formation of a North Korean supra-cabinet body to oversee foreign direct investment approvals under a 10-year plan announced in January 2011. The positive interpretation of this development is that this body could potentially constitute a one-stop shop for investment approval and put a stop to the cascading corruption that our survey results indicate deters investment. Alternatively, the composition of this group could also be read as a map of the regime’s internal political economy, specifically the organizations and factions best positioned to benefit from the extraction of rents from foreign investors. Reputation is not established by passing laws or even creating new institutions, but through the iterated play between state and economic agents that takes place over time. To date, the changeability of North Korean policy has prevented such a positive dynamic from emerging.
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