When it comes to "frontier markets", North Korea is not so much on the outer fringes as right over the edge for investors. But despite all the problems, what case can be made for considering this country at some stage? An expert takes a look.

Editor’s
note: The term “frontier market” is bandied about quite a good deal in the
investment world and this publication, like others, gets its fair share of
views about countries seen as promising for those willing to take on the
requisite risk. But very few mention North Korea, a jurisdiction that
has been run by a hard-line communist regime since the early 1950s and which is
infamous for its mix of personalty-cult leadership, repression and lack of
contact with the outside world. The jurisdiction was back in the headlines this week over reports of a further nuclear test, which has provoked international condemnation. In the light of such things, is there an investment case that can or should
be made for this place?

Geoffrey See, who is the managing director of Choson Exchange, his
eponymous non-profit organisation focused on business, economics and legal
education for young professionals and policymakers in North Korea, gives his
views about the country. See has advised hedge funds and private equity firms about
North Korea; he has also worked at Bain & Co. His
views here are not necessarily endorsed by this publication, but it is
delighted to share the insights about what might one day be a country more
familiar to investors than it currently is. (Choson Exchange has offices in Beijing, Singapore and Boston.)

This question must seem utterly contrarian
with the recent North Korean nuclear test, coming on the heels of a rocket
test, and the likely chorus of think tank voices that will follow calling for
increased sanctions. Given the obsessive secrecy that shrouds North Korea and
its tendency to be in the news for the wrong reasons, it is unsurprising that
most western investors overlook the country. However, niche interest in North
Korea is rising among some American, European and Southeast Asian investors,
not to mention increasing investments from mainstream Chinese investors. Hedge
funds trade defaulted North Korean debt instruments while other investors take
stakes in various commodity, property and retail opportunities.

I recently spoke at a conference a hedge
fund organised for their investors. The fund had some exposure to North Korea.
For investors looking to the long-term and interested in yield, it is easy to see
why this niche interest exists. After all, a friend who provides working
capital loans in Pyongyang charges interest greater than 50 per cent on an annualised
basis to the more reputable borrowers in the country – an indication both of
opportunity (scarce capital) and risks (potential for default).

But is North Korea invest-able for more
mainstream investors?

The answer to this question is
unfortunately a non-resolute perhaps…North Korea is slowly opening its
market to foreign investors. But foreign businesses in North Korea
still struggle with weak governance, arbitrary rules and an opaque operating
environment. 

Theory
and practice

Emerging markets fund manager James Passin,
in an interview with Bloomberg News
recently, said how North
Korea has geographical and natural
advantages that favor its growth. Like nearby Mongolia,
which has seen an incredible resource-driven boom over the last five years, North Korea has
abundant underground resources that include coal, gold, and iron. Similar to Mongolia, North
Korea is situated next to booming China, dynamic South
Korea and affluent Japan, and well placed to benefit
from these markets. Unlike Mongolia,
North Korea’s
larger population, at around 25 million, has the potential to become a
manufacturing hub and emerging consumer market.

Such potential is of course highly
theoretical and realisable only in the longer-term. North Korea has resisted
traditional development options for many years through a mix of inconsistent
economic policies, paranoid security measures, and the inability to provide
infrastructure to would-be investors. Simple decisions are hampered by a
bureaucracy that clings to secrecy – when we ask investment policymakers how an
entrepreneur would apply for licenses for certain businesses, the typical
response would be “I don’t know…but try and find out.”

Despite the gap between present performance
and long-term potential, I am cautiously optimistic about the next five years.
Aid, trade and investments from Russia
and China
have increased significantly over the last five years, and are likely to grow
over the next five years. A newly elected South Korean government might
re-engage with North Korea
with investment and aid.

A critical factor that has escaped the
attention of many observers is how mindsets have changed. There is an active
entrepreneurial community on the ground in North Korea. This community does
not just include the well-documented informal markets where small stall owners
peddle a range of products, but also includes ex-government officials or
state-owned enterprise managers who set up relatively large businesses in
industries ranging from restaurants to property development. A venture
capitalist who joined an education programme we conducted in North Korea
remarked that this rampant commercialism reminded him of the early years of the
Chinese economic take-off.

This entrepreneurial energy if rightly
channeled can lead to significant economic growth. The North Korean government
has committed itself publicly to developing the country, and has been making it
easier for investors to navigate the system, albeit at a lethargic pace.

Choosing
the right route

For financial investors, private equity is
the most appropriate instrument given the limited range of liquid instruments
providing exposure to North
Korea and the time horizon needed to realise
a return.

Effective execution is the key to success
in the North Korean market, and the companies that we know to have done
relatively well in the market tend to share a few characteristics: significant
hands-on involvement in operation and governance, boots on the ground, quality
relationships with North Koreans who can be trusted, and a broad network in the
country that facilitates due diligence and troubleshooting. Unfortunately,
successes are still relatively rare, and investors need to go in fully aware of
the challenges of this market.