North Korea's Kim Jong Il died according to South Korean media. He will be succeeded by his son Kim Jong Eun, who has been officially groomed for this role for about 2 years now.

There is no question that markets will be volatile for a week or two. As of 11:30am on Monday, Dec 19, the won is down 1.4% and the Kospi has lost 4%. But, what are the chances of impending regime collapse or a military aggression during this time of heightened vulnerability for the Northern state?

We believe that the chances of a military aggression are limited. Kim Jong Il suffered from pancreatic cancer, so his death was more or less anticipated by the Northern leadership.

Despite this, North Korea remained very engaged in efforts to restart the six-party talks. In fact, many interpret the aggressions of 2010—the sinking of a South Korean warship and the shelling of a South Korean island—as efforts to bring its opponents back to the negotiating table. North Korea has no record of aggression while engaged in negotiations with opponents. Having said that, the Northern regime will be prickly over coming months and we should look out for signs that it is withdrawing from low-level diplomatic efforts to mend fences.

The chances of a regime collapse have increased with the death of Kin Jong Il. This could be brought about either by a coup or by a failed attempt to reform the political and/or economic system (the Gorbachev legacy).

There is a slight chance that regime collapse would lead to anarchy and civil war. However, North Korea's centralized organization and concentration of power should prevent this worst of all outcomes. It would also call for the deployment of an international army, given the risk of nuclear proliferation.

Unification scenarios

A big bang unification comparable to the German model is not an option for Korea. German reunification is estimated to have cost between USD600 billion and USD1 trillion over 10 years, equivalent to 30%-50% of West German GDP.

However, the price tag would be significantly larger in the case of Korea, in effect ruling out this option altogether.

To begin with, East Germany's population amounted to a quarter of the West's population, while North Korea's population amounts to half the South's population.

Second, East Germany was the wealthiest of the Soviet satellite states with a per capita income equivalent to 1/4 of the West's. The equivalent number for the two Koreas is 1/10. Finally, North Korea's human capital may be in a worse state than East Germany's. The World Food Program estimates that 40% of the North's population suffers from malnutrition.

The degree of international isolation may have taken a further toll on human capital. For instance, in the early 1990s a UN mission found insufficient skills in the North Korean government to identify suitable investment projects, prepare feasibility studies, and negotiate with prospective investors. A 2001 survey of South Korean investors showed that Northern ignorance or unwillingness to follow accepted international trade practices was a major impediment to FDI.

Long-term association is a much more realistic scenario for the two Koreas and, indeed, the option favoured by Seoul. This would allow South Korea to spread the costs of lifting Northern living standards over many years and, thereby, cushion the shock for the South Korean economy.

Presumably, FDI and productivity gains, rather than direct fiscal transfers would play a much larger role in the convergence process. Moreover, there are no legal obligations to pay for the cost of reconstructing the North.

The Korean War ended in 1953 with the signing of an armistice but no formal peace treaty. North and South are two distinct countries and it is only under reunification that the South would have a formal commitment to shoulder the financial burden of the North.

Of course, the question is, can it be done?

In West Germany, at the time, there was a saying that if the West doesn't bring the D-Mark to the East, the East would come to the D-Mark. There are a number of factors that suggest Korea can choose a gradual approach without risking mass migration from the North.

To begin with, there has been much less contact between the two Koreas than between the two Germanys. In the wake of Willy Brandt's Ostpolitik—a policy of rapprochement and small steps—West Germans could travel to East Germany and relatives could meet each other regularly.

Contacts between Koreans in the South and the North have been confined to occasional family reunions and even those are suspended after each flare-up of hostilities. Less familiarity between the two sides will reduce the incentives for migration and weaken the moral imperative for solidarity in the South.

Also, South Korea has a much smaller welfare system than West Germany and, in fact, most OECD countries. This greatly reduces the incentives for illegal immigration and contains the costs in the event of legal migration.

Front loading of assistance would further reduce the incentives for migration.

The RAND Corporation discusses a scenario in which South Korea doubles North Korean GDP over 4-5 years, arguing that rapid improvement in living standards would provide sufficient hope among the populace and stabilize the new state.

RAND also points out that there are many countries that function with tolerable effectiveness notwithstanding deep economic divisions. Examples include Belgium (the Flemish and Walloons), East and West Ukraine, Italy (the Mezogiorno and the more prosperous Piemonte), and the United States (California and Mississippi, not to mention Manhattan and the Bronx). This should hold even more for two Koreas that remain separate states.

There are other factors that would help contain the costs relative to a big bang approach German style.

To prevent mass migration Germany converted the Eastern currency at a rate of 1:1 to the D-Mark and raised Eastern wages to 80% of the Western level despite much lower productivity in the East.

Germany also created much legal uncertainty by allowing people to reclaim their property expropriated by the Soviets. Particularly the last two factors held back badly needed FDI and are the reason that 20 years on Eastern incomes still haven't caught up with the West. By maintaining separate states and wage levels, the two Koreas would leave in place powerful incentives for capital to flow from the capital-abundant South to the labour-abundant North.

The much larger disparity between the two Koreas relative to the two Germanys becomes an advantage if instant convergence is no longer the goal. In particular, the doubling or tripling of living standards in the poorer neighbour is much more affordable.

Large savings can be expected from cutting the North Korean military apparatus to size. The US State Department estimates that the North Korean military absorbs about 20%-30% of GDP, or vastly more than East Germany's military before unification.

North Korea has large mineral wealth, estimated at about 140% of GDP at current market prices. In contrast, South Korea imports most of its mineral resources. The North's mineral wealth could create great synergies with the South's industries, including steel and information technology.

Finally, South Korea would not be alone in providing assistance to the North. Normalization of North Korean relations with the international community would unlock funding from international organizations such as the IMF and World Bank. Participants in the six-party talks also hold stakes and are likely to contribute. China shares a 1,400 km border with the North and is weary of refugee flows. The US is concerned about nuclear proliferation. Japan as a former colonial power would also be expected to contribute. And, Russia again shares a border with North Korea, if significant shorter than China's.

Prefunding the costs?

Should South Korea accumulate fiscal reserves in preparation for unification? The theoretical rationale is compelling: Since the deadweight loss of taxes rises more than proportional with the tax rate, it is efficient to spread the funding over many years. Also, many countries have accumulated fiscal funds with great success to prefund pension related expenditures or to preserve oil wealth for future generations.

In August of 2010, President Lee Myung-Bak floated the idea of a unification tax and turning the existing South-North Cooperation Fund (worth about USD870 million) into a unification fund. However, prefunding of unification is problematic for a number of reasons.

The creation of a unification fund alone makes little sense, because any saving by the fund could be offset by wider deficits and higher government debt. In this fashion the tax destined for unification could be used for any other purpose.

To make sure that Korea really saves for rainy days the entire net wealth of the Korean government would have to be monitored or, alternatively, the change in its net wealth, the fiscal deficit. Even then, reducing government debt rather than setting up a unification fund should be more cost effective, given that the interest paid on debt is probably higher than the risk-adjusted return to be earned on the fund.

Other complications arise. Since the timing and cost of unification is highly uncertain, it is difficult to define the desirable level of the government's net worth and the optimal speed of its build-up.

The danger then is that the reserves could grow very large and, thus, become vulnerable to governance problems. Apart from that, the unclear outlines of the future challenge make fiscal austerity a hard sell politically. Finally, a South Korean pool of money earmarked for assistance to the North could create complacency on the part of other donors.

In view of these realities, a strategy of fiscal prudence –pursued by successive Korean governments and enjoying broad support by the electorate—seems to be a reasonable choice. Korea's gross government debt is around 30% of GDP.

The government aims for a balanced budget by 2013/14, which would bring down the debt even further. This leaves significant scope for debt financing (that is, minimizing deadweight loss of higher tax rates), when the regime in the North does eventually collapse.