Peace worries some Korea watchers more than war

SINGAPORE (Reuters) - If there is one thing more worrying for North Korea watchers than the behavior of ailing leader Kim Jong-il, it is what might happen once he is gone.

The eventual collapse of Kim's regime is widely regarded as inevitable. The only questions are when, and how. And for most analysts, the risk that South Korea's economy is hammered by the costs of reuniting with the impoverished North is a far greater concern than the remote chance of a devastating war.

War is regarded as highly unlikely. Reunification is almost inevitable. And the costs are widely expected to be enormous.

"In assessing catastrophic risk potential, we would rate an internal leadership vacuum and social breakdown in North Korea as a likelier credit threat in the medium term than a serious outbreak of military hostilities," Credit Suisse said in a report this year on the key risks for South Korea.

North Korea's GDP per capita is only around 5 percent of the South's. Its population is nearly half the size of the South.

Given the economic pain produced by German reunification, where the income gap was far narrower and the population absorbed relatively smaller, most analysts have assumed South Korea will face a painful fiscal burden that will weigh on it for years.

Credit Suisse estimates the cost of reunification will be around $1.5 trillion, roughly one-and-a-half times South Korea's GDP, based on the assumption that North Korea's per capita GDP was raised to about 60 percent of the South's over 10 years.

Other estimates of the cost have put it as high as 3 or 4 times South Korea's GDP. Most analysts expect a period of severe hardship for the South, likely to persist for years.

SHOULD THE RISK BE REASSESSED?

Yet some analysts have challenged this negative view.

A report last month by Goldman Sachs economist Goohoon Kwon argued that the costs of reunification need not be prohibitive and said North Korea had huge growth potential.

Kwon was strikingly bullish on the prospects for a united Korea. "We project that a united Korea could overtake France, Germany and possibly Japan in 30-40 years in terms of GDP should the growth potential of North Korea be realized," he said.

If credible, the analysis could overturn risk assessments of South Korea, with reunification being viewed wholly differently.

The Goldman report argues that North Korea has strong untapped growth potential, partly due to mineral wealth estimated to be worth around 140 times its 2008 GDP.

But Kwon's forecasts are also based on a key political assumption -- economic integration will be peaceful and gradual. As he noted, other scenarios may have "diametrically different implications for the economy and markets."

Kwon said the German model would be prohibitively expensive for North Korea. The least expensive option would be Hong Kong-style integration in which two economic and political systems coexisted with limited migration between the two.

FEW PLANS SURVIVE CONTACT WITH REALITY

But while a gradual and well-planned economic integration would be clearly optimal, there are several reasons why the reality may prove much messier, and much riskier.

Firstly, any integration while an authoritarian regime in North Korea remains in place is difficult to envisage.

Ian Bremmer, president of the Eurasia Group risk consultancy, said the North's leaders had no desire to end their isolation and rigid social controls -- because they would lose power.

"If half the people of North Korea saw 20 minutes of CNN they would realize how egregiously their government lies to them about life beyond the walls," he wrote in his book The J-Curve. "That realization could provoke widespread social upheaval."

Far more likely is that reunification is suddenly thrust upon South Korea when the regime in the North collapses. Policymakers planning for the collapse of the regime generally group the scenarios into two groups -- "hard landing" and "soft landing."

Soft landing scenarios envisage Kim or a post-Kim military leadership recognizing that wide-ranging reform is needed, and going through this reform as part of a phased reunification.

But most expect some kind of "hard landing" -- either the complete collapse of the government, or even worse, a descent into civil war with various factions fighting for power.

South Korea will probably have little control over the timing of reunification -- it is likely to happen in the midst of a crisis, in which there may well be a humanitarian disaster to deal with as well as long-term economic policy to be mapped.

And implementing a gradual integration in such circumstances may be impossible. The people of North Korea, just emerging from decades under dictatorship, would be unlikely to accept being asked to quietly wait as the two economies gradually merged.

The Hong Kong model may be of limited relevance to Korea -- China was able to maintain two separate systems with tightly controlled migration because it is an authoritarian state.

But democratic South Korea would find it extremely difficult to prevent citizens of the North migrating south in search of better lives, without causing widespread anger and even unrest.

One issue mitigating the economic risks to the South is that a large amount of aid is likely to be provided by other nations.

But for investors, reunification remains a key risk. Predicting how it will happen is impossible. But of the wide range of possible scenarios, many involve heavy economic costs for the South, as well as unrest and massive social upheaval.

Most foreign investors will want to get out of South Korean assets before it happens. If a united Korea proves as successful as Goldman Sachs forecasts, they can always return.

(Editing by Dean Yates)