CENTER FOR FINANCIAL STABILITY Dialog Insight S o l u t i o n s North Korea: From Hyperinflation to Dollarization? Steve H. Hanke 1 This article first appeared in the July 2013 issue of Globe Asia. For years, North Korea has been crushed by a communist command economy producing little besides mass starvation. More recently, the plight of North Korea’s economy has been exacerbated by harsh, foreign economic sanctions – which only seem to have driven the regime to double down on its nuclear ambitions. Following North Korean supreme leader Kim Jong-il’s death in December 2011, many around the world had high hopes that his successor (and son), Kim Jong-un, would launch economic and political reforms. Unfortunately, in the year and a half since he assumed power, the new supreme leader has not delivered on his advertised economic reforms, and misery continues to grip all but those in North Korea’s communist upper class. During the past few months, North Korea has been the subject of outsized news coverage. The recent peacocking by the Supreme Leader – from domestic martial law policies to tests of the country’s nuclear weapons capabilities – has successfully distracted the media from North Korea’s economic woes. Indeed, behind the saber-rattling, the missile tests, and the basketball games with Dennis Rodman, is an economic story – one with important geopolitical implications, not only for North Korea, but also for China. 1 Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C. Prof. Hanke is also a Special Counselor at the Center for Financial Stability. You can follow him on Twitter: @Steve_Hanke 1120 Avenue of the Americas, 4th Floor New York, NY 10036 T 212.626.2660 www.centerforfinancialstability.org CENTER FOR FINANCIAL STABILITY Dialog Insight Solutions North Korea’s Hyperinflation For years, North Korea’s currency, the won, has been officially pegged to the U.S. dollar. That said, exchange controls and a plethora of associated regulations and harsh penalties have rendered the won inconvertible. This, of course, has given rise to a healthy black market for foreign currency. North Korea’s monetary dysfunction has been accompanied by severe inflation problems. In 2009, the North Korean government attempted to address these problems by implementing a phony currency “reform” program, which it promptly bungled. The so-called reform was actually just a currency redenomination program, which arbitrarily lopped two zeros off every won note. North Koreans were given less than two weeks to exchange all of their won for new notes. And, the government set limits on the quantity of old won a family could exchange for new won. For those North Koreans who had saved a few too many won, the redenomination program was effectively a wealth tax program, too. It should come as little surprise that Pyongyang’s bungled currency reform sparked a panic in North Korea’s primitive, underground markets for goods and services. These markets, which developed out of necessity during the famine of the 1990s, primarily exist to counteract shortages that result from state control of agriculture. Indeed, the United Nations has estimated that 50% of the calories consumed by North Koreans come from food purchased in these underground markets. The price of rice, for example, promptly skyrocketed during this period (see figure 1). -2- currency. In consequence, the value of plum won the the value currency. consequence, In more and more merchants in the underground markets based news service. With the bungled currency refor exchange-rate data. Black-market exchange rate data Figure 1 North Korean Won per Kg of High-Quality Rice 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 0 To gauge the inflation temperature in cases such as Source:NK. Daily Aug-09 Sep-09 Oct-09 Nov-09 CENTER FOR FINANCIAL STABILITY Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 The Price of Rice in North Korea Sep-10 Oct-10 Nov-10 Dec-10 Dialog Jan-11 Feb-11 Mar-11 Apr-11 Insight -3- May-11 meted on the black market (see figure 2). 2). (see figure market onblack metedthe Jun-11 m, the demand for hard currency accelerated, as for the won are collected by Daily NK, a Seoul- Jul-11 required required transactions to be conducted in hard Aug-11 Solutions North Korea’s, mustwe obtain black-market Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 rate. As figure 3 shows, the 2009 panic sparked an sparked 2009 panic shows, the 3rate. As figure Well, black-market exchange rate data allow us to r Figure 2 North Korean Won/U.S. Dollar Exchange Rates (y-axis inverted) 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Note:purposesFor theillustrating of val declining Source: NK. Daily So, what happened to the overall price level in Nor Aug-09 Sep-09 Oct-09 Nov-09 CENTER FOR FINANCIAL STABILITY Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 The Fall in the Value of the North Korean Won May-10 Jun-10 The Black-Market The North Korean Won/U.S. Dollar Excha Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dialog ue of theue of North Koreanrelative Won, tothe U.S. dol Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 Insight inflation surge in North Korea. Korea. North in surge inflation -4- May-11 each a reliable estimate of North Korea’s inflation Jun-11 Jul-11 Aug-11 th Korea in the wake of the currency reform? Sep-11 Solutions Oct-11 Nov-11 Dec-11 Jan-12 nge Rate Feb-12 Mar-12 Apr-12 May-12 lar,the y-axis is inverted. Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 CENTER FOR FINANCIAL STABILITY Dialog Insight Solutions Figure 3 North Korea's Monthly Inflation Rate 1000% 926% Implied Monthly Inflation Rate - From the Black-Market Exchange Rate Monthly Inflation Rate - From the Price of Rice 800% 600% 400% 348% Monthly Inflation Rate Inflation Monthly 200% 0% -200% Jul-10 Jan-11 Jan-10 Jun-10 Oct-10 Apr-10 Sep-10 Feb-10 Dec-10 Dec-09 Aug-10 Nov-10 Mar-10 May-10 Sources: Daily NK, Federal Reserve Economic Database, and author's calculations. Note: The inflation rates are calculated from the movements in the average black-market KPW/USD exchange rate and the average price of rice of the three North Korean citis,:Pyongyang, Sinuigu, and Hyesan. As the chart illustrates, the inflation rate implied by the change in the black-market exchange rate proves quite accurate, as it tracks closely with the inflation rate implied by changes in the price of rice. Thus, we can conclude that the inflation crisis that began in 2009 quickly accelerated into hyperinflation, which occurs when the monthly inflation rate exceeds 50%. It was not until mid-January 2011 that North Korea’s hyperinflation episode finally came to an end (see figure 4). -5- CENTER FOR FINANCIAL STABILITY Dialog Insight Solutions Figure 4 North Korea’s Hyperinflation Episode Month with Highest Equivalent Time Required Start Date End Date Highest Monthly Daily Inflation for Prices to Inflation Rate Inflation Rate Rate Double December Mid-January Early March 926% 8.07% 9.1 days 2009 2011 2010 Source: Daily NK and Author’s Calculations. Note: The inflation rates are calculated from the movements in the average black-market North Korean Won/U.S. dollar exchange rate in three North Korean cities: Pyongyang, Sinuigu, and Hyesan. These estimated inflation rates are revised from the author’s previous estimates to include a more precise methodology. The new methodology standardizes the monthly inflation rates to a 30-day period by extrapolating the calculated rates accordingly. See: Steve Hanke and Nicholas Krus, “World Hyperinflations” in Randall Parker and Robert Whaples (eds.) (2013) The Handbook of Major Events in Economic History, London: Routledge Publishing. During the hyperinflation period, many North Korean consumers began to exchange their ever- depreciating won for more stable foreign currencies, such as the Chinese yuan and the U.S. dollar, in a desperate attempt to preserve their wealth and purchasing power. Although North Korea is no longer experiencing hyperinflation, elevated rates of inflation continue to plague the country’s economy. Indeed, I estimate that North Korea experienced an annual inflation rate of 116% in 2012. As a result, the won’s popularity continues to decline. North Korea’s “Dollarization” It is not surprising, therefore, that the Chinese yuan and U.S. dollar are now being used more widely in North Korea than the won. According to Daily NK, North Korean markets along the Chinese border now conduct approximately 80% of their transactions in Chinese yuan. Markets farther from the border are said to conduct approximately 50% of their transactions in U.S. dollars. -6- CENTER FOR FINANCIAL STABILITY Dialog Insight Solutions This confirms that North Korea is experiencing a phenomenon that goes hand-in-glove with elevated inflation – “spontaneous dollarization.” This phenomenon of voluntarily dumping the domestic currency in favor of a stable foreign currency (not necessarily the U.S. dollar), has been widespread in recent years, despite the fact that Pyongyang has criminalized the circulation of foreign currencies on the black market.