Participation in the Kaesong Industrial Complex and its impact on productivity: South Korean textile firms’ experiences

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Highlights

  • This paper examines the productivity of firms investing in the KIC with a focus on the textile sector.

  • We used a DID framework and extended to the event study framework of Gathmann, Helm, and Schönberg (2018).

  • The results reported that the KIC firms experienced the increased sales.

  • However, the improvement in sales had not lead to improvements in productivity.

  • That is, improvement in productivity through FDI cannot be found in the empirical results.

Abstract

This paper examines the effects of participating in the KIC on firms’ productivity using firm-level data from 1998 to 2012, focusing on the textile sector. To do this, we implemented PSM estimations employing the radius matching method with 0.01 caliper and 10nearest-neighbor matchings with replacement. We found 100 matched firms in control groups(domestic firms) that corresponded to each of the 10 treated firms.

For analysis, we used a difference-in-differences (DID) framework and extended the basic DID framework to the event study framework of Gathmann et al. (2018). The results reported that the treated firms experienced the increased sales but the improvement in sales had not lead to improvements in productivity. These results can be found in the DID event study as well as the DID analysis. That is, improvement in productivity through FDI cannot be found in the empirical results.

Introduction

The Kaesong Industrial Complex (KIC) was symbolic, economic cooperation between South and North Korea from 2004 to 2016. Beginning in 2004, the KIC’s operation had been relatively stable in spite of several crises resulting from deteriorating inter-Korean relations. KIC also had grown dramatically regarding size until it was shut down in the wake of the fourth nuclear test by North Korea in January 2016. At present, whether the KIC will resume operations is unclear, but as inter-Korean relations appear to be thawing, the prospects for the discussion of inter-Korean economic cooperation and resumption of the KIC are high. The number of firms operating in the KIC had increased to 123 by 2016, with cumulative total sales of more than $ 2.2 billion. And, the industrial complex employed approximately 53,000 North Korean workers hired by South Korean firms, as well as more than 700 workers from South Korea.

Despite the uncertainty concerning reopening the complex, a first evaluation of the KIC can provide insights for firms contemplating participating in South-North economic cooperation in the future. Additionally, analyzing the performance of firms in the KIC is of great value as necessary information for discussing future economic cooperation and establishing related policies because South Korean firms could play an important role in economic cooperation between the two Koreas.

There are few previous empirical studies that analyze the performance of firms using KIC internal data (KICOX, 2010; Sukki, 2007) and survey data for those firms that have been part of the complex (KDI, 2008; Hoon, 2007; Dong et al., 2008). As an exception, Jung (2015) studied the performance of KIC firms and found that participation of KIC has no effect on the firms’ productivity. However, this study is limited in the methodology because the evaluation for the performance of KIC firms is mostly on correlation analysis. Specifically, in comparison with the KIC firms, those firms in the control groups includes all foreign-invested companies, export companies, and strictly domestic invested companies so that firms in control groups are not proper counterfactuals for the KIC firms.

In our study, we restrict firms in the control group to Korean firms that only sell domestically. One of distinguishing features of the firms in the KIC is that they could hire workers at very low wages, making them engaging in pure vertical FDI s, in which the parent company imports all the goods produced in the KIC using very low wage. Thus, the KIC firms are an ideal example of a vertical FDI engaging firms because these firms maximize their profits by establishing local factories to take advantage of the abundant cheap production factors of the host country (Helpman, 1984, 1987; Helpman, 1987). The KIC firms provide a unique opportunity to investigate the role of a pure vertical FDI s because whether a firm engages in a genuine vertical FDI or not is not clearly distinguished by the analytical data in most previous studies.

The reason is that in most cases firms decide to make investments by considering both the utilization of rich production factors in the host countries along with market access (Markusen, 1995; Hanson et al., 2001). Although theories on FDI are very diverse, most theories have both elements of the use of cheap factors of production and the use of new market access in FDI decisions.

As a result, it is difficult to distinguish between vertical and horizontal characteristics clearly. In practice, most of the FDI decisions of firms are influenced by both factors, so it was practically not possible to isolate the impact on productivity due to the utilization of rich production factors from the effect due to new market access.

Many studies related to vertical FDI have conducted as follows. According to Hayakawa and Matsuura (2011), firms engaging in pure vertical FDIs are more productive than domestic firms because trade costs would make the FDI of purely domestic firms with low productivity unprofitable and only firms with high productive remain profitable after their FDI decision.

Milner et al. (2006) examine the effect of industrial linkages between Japanese firms located in Thailand on pattern of FDI using industry data set constructed from firm-level. The results show that in addition to factor cost advantage such as lower labour cost industrial linkages can leads to agglomeration of FDI. Also Nishitateno(2013) analyzed the relationship between FDI and intermediate export. The result shows that FDI by Japanese upstream firms lead to more exports of intermediate goods from Japan.

Some research present that the presence of domestic competition undermines bargaining power of the foreign parent firms and their ownership shares in the joint ventures with domestic firms (Nakamura and Zhang, 2018). In addition, there is also a study on whether FDI promotion policies can actually attract inward FDI in Japan (Hoshi and Kiyota, 2019).

There are also empirical studies analyzing the relationship between FDI and a firm’s productivity and show that a firm’s investment decisions reflect productivity levels and that the most productive firms decide to invest abroad, that intermediate productive firms become export companies, and that the least productive firms remain in the domestic market (Helpman et al., 2004).

Similarly, previous studies on the relationship between productivity and FDI examine the mode of investment through estimated productivity such as Olley and Pakes (1996) and Levinsohn and Petrin (2003).

In this paper, exploiting a pure vertical FDI in the KIC, we first examine pre-FDI productivity and firms’ FDI decision in the KIC and verify that we could get the same conclusion of high productivity firms are more likely to engage in the FDI as previous studies (Helpman et al., 2004). Second, we examine the impact of a pure vertical FDI on post-FDI productivity. The analysis is unique in that we could isolate the impact of a pure vertical FDIs of firms on productivity due to utilizing cheap labors from the impact from having any access to a new market.

Especially, the analysis of the post-FDI impact on productivity is important because most of the previous studies focused on pre-FDI conditions and the investigations on the change in the productivity of firms after investing in KIC are rather scant. Our study is most closely related to recent two studies that examined the impact of labor cost change on a firm’s productivity. Lucht and Haas (2015) examined the effect of the influx of cheap migrant workers on firms’ productivity and found that those firms exploiting cheap wage cost by hiring more migrant workers had high productivity. Alvarez and Fuentes (2018) also studied the impact of the change in wage costs using the increase in minimum wage.

They found the increase in minimum wage reduced firm’s productivity, which is measured by using various measures for TFP, and also found that the impact is highest in the industries that most heavily rely on unskilled workers. Our study is distinguished from these studies in that the impact of labor cost change is materialized by the introduction of a pure vertical FDI and the identification of causal effect is clean because it is taken place in the KIC area.

For the estimation of the causal effect of a pure vertical FDI on firm productivity, we use an extended version of the difference-in-differences method which is also called as the event study method in Gathmann et al. (2018). We use the KIC firms (i.e., pure vertical FDI firms) as treatment group and firms that only sold to domestic market as the control group, and the introduction of FDI occurred around 2005 for the dataset that spans from 1998 to 2012. As a result, the DID framework becomes our natural choice to analyze the changes in productivity between the KIC and the purely domestic firms before and after the pure vertical FDI interventions in the KIC. We focus on the textile industry, which accounted for the majority of production in the KIC.

We found that the FDI firms in the KIC experienced productivity improvements after investment. The DID results indicate that productivity gain after the intervention is 105 %. This result is consistent with the positive effect of cheap migrant workers on firms’ productivity in Lucht and Haas (2015). Further, our event study analysis allows us to examine the dynamic effects of the FDI intervention. For the three years after the intervention, productivity gains to the KIC firms were as large as 134 %. However, the effect did not last long. Three years after the intervention, productivity gains for the KIC firms become statistically insignificant.

The paper is organized as follows. First, in Chapter Ⅱ, we explain the data used in the analysis. In Chapter Ⅲ, we propose the empirical analysis strategy and methodology. Chapter Ⅳ includes our interpretation of the results. Last, in Chapter Ⅴ, we summarize our findings and offer concluding remarks.

Section snippets

Data

The dataset covers firms’ data from 1998 to 2012. We transform annual data to the average of every two years’ data to minimize losing information due to intermediate missing data on input factors in productivity estimations.1

Methodology

To explore the influence of vertical FDI participation through the KIC, we use a difference-in-differences (DID) framework. As vertical FDI participation are not randomly selected, there may systematic pre-participation differences in outcome across treated and control firms. The DID estimation can account for pre-participation differences in outcome but it still needs to assume that there is no pre-intervention trend difference across treated and control firms in the outcome variable for a

Pre-intervention productivity

We estimate the Eq. (3) using the pooled OLS method from 2000 to 2004. The results are reported in Table 4. The coefficient estimate for treated group is positive but not statistically significant. In Table 4, the result shows that, among those treated and control firms, large (in sales), capital-intensive, and greater (in the number of employees as well as total assets) firms are the firms with the high productivity level.

Post-intervention productivity

We estimated Eq. (2) via Models 1 and 2, which are presented in Table 5.

Conclusion and discussion

The Kaesong Industrial Complex (KIC) was a symbolic economic cooperation between the two Koreas. Beginning in 2004, the KIC was a relatively stable operation in spite of several crises resulting from deteriorating inter-Korean relations, which grew greatly in terms of size until it was shut down.

Presently, whether the KIC will be reopened remains unclear; however, as inter-Korean relations thaw, economic discussions on inter-Korean economic cooperation are being held. The KIC administrative

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