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Risk is rising on the Korean peninsula. We ask a political and market expert about the possible consequences.

Tensions between the US and North Korea have escalated this summer, especially in the wake of North Korea’s successful test launches of their first intercontinental ballistic missiles (ICBM) in July. While there is debate in the military and intelligence analyst community about whether these missiles would be capable of reaching the US mainland or carrying a nuclear warhead, the launches and ensuing war of words between Washington and Pyongyang represented a significant shift on the diplomatic front.

US President Donald Trump vowed to meet any North Korean threat with “fire and fury”, a dramatic change in tone than previous administrations have used with North Korea. For its part, the North Korean military presented plans for further missile launches in the direction of Guam, a US territory in the Pacific Ocean and host to US naval and air bases. Stoking tensions even further, North Korea fired a missile over Japanese airspace on August 28 and conducted a reported nuclear test on September 3, an apparent challenge to the resolve of leaders in the region, especially President Trump.

The rise in geopolitical risks around the North Korean threat impacts economies and markets in nations around the region, which Ed Wiltshire, Portfolio Manager for emerging markets and Asia/Pacific equities, addresses later in this article. First, we asked Jenny Town, assistant director of the US-Korea Institute at Johns Hopkins University in Washington, to update the assessment she provided on North Korea in our AIQ Issue 002 earlier this year.

What has changed in the region since the July ICBM tests and President Trump’s heated words in response?

Jenny Town: The American media characterized the launches as game changers and a manifestation of a real nuclear threat. These reports tended to focus on the capabilities of these missiles—whether they would be able to deliver a nuclear warhead to California, for example—rather than their strategic importance.

For those who live in the region, as well as those who have followed North Korea for some time, the recent launches did not make as dramatic of an impression. As North Korea analysts, we have known the country has been working on a broader range of missiles for a while. What has changed in our view is the timeline; it usually takes several rounds of trials and testing to get ICBM technology right, but the success of these initial tests accelerated our opinion of how quickly these missiles could become operational. Plus, the tests may have demonstrated the trajectory and range of these ICBMs, but there is no consensus in the analyst community about their payload capacity and re-entry capabilities. It’s difficult to get an accurate assessment of that from videos and photos.

Messages coming out of North Korea and from Kim Jong-un have been consistent, especially in response to US President Trump’s escalating war of words and his “fire and fury” talk. North Korea maintains the missile program is meant for self-defense and second-strike capabilities, only to be used to retaliate if attacked. The North Koreans are masters of brinkmanship and they are careful not to back themselves into a corner. Unfortunately, this hasn’t been the case with President Trump and the US. There’s no clarity as to what the current policy is, and differing statements from different levels of US leadership has led to confusion. As a result, the North Koreans don’t know who’s in the driver’s seat and where to focus their attention.

It’s much the same among US allies in the region. For the governments of South Korea and Japan, “fire and fury” is not a coordinated position. It goes against decades of carefully managed diplomatic efforts between the countries. These statements have stirred a lot of anti-Trump sentiment in South Korea, along with resurgent calls for South Korea to develop their own nuclear weapons because many feel the country can no longer rely on the United States if the US is forced to choose between San Francisco and Seoul.

What has been the reaction to President Trump’s statements about the US “going it alone” to increase pressure on the North Korean leadership?

JT: When Trump raises the possibility of unilateral military action against North Korea, it becomes more difficult for these allies to believe the US has their interests at heart. His statements, however, contradict what other military and diplomatic officials have also been saying. In the eyes of many of the region’s political leaders, US Secretary of State Rex Tillerson seems to have been sidelined, so they wonder who really speaks for US foreign policy. Does Tillerson have any influence over Trump? In regards to the US military, will they stand in the way of Trump if he does decide to go it alone against North Korea?

In South Korea, the idea of the US “going it alone” and waging “preventative war” has created problems for President Moon Jae-in. In fact, President Moon has said the US cannot launch any military action against the North without the consent of South Korea, and Moon has said he won’t be giving consent to any unilateral action. Trump’s statements have exacerbated tensions between the US and South Korea and raised concern among the South Korean public.  

Regarding the recent round of sanctions from the UN on North Korea and from the US on individuals and companies tied to the North Korean leadership (primarily Chinese and Russian interests), are expectations any different than what was tried previously?

JT: The recent round of United Nations sanctions approved unanimously by the UN Security Council on August 5 (UN Resolution 2371) only took a few months to draw up and secure approval. Previous resolutions regarding sanctions against North Korea have taken longer to approve, and in many cases were also tougher than what Resolution 2371 outlines.

In certain respects, the latest sanctions are more symbolic than anything. They do show solidarity among the international community in their willingness to condemn North Korea for violating previous resolutions. But the sanctions are also rife with loopholes, such as the quota limits on use of North Korean laborers for projects in other countries; there already exists a large pool of North Korean workers outside of the country, and quota numbers are self-reported and easy to fudge.

For the recent US sanctions targeting specific companies and individuals with connections to the North Korean leadership, these sanctions are unilateral in nature and it will be difficult to compel China or Russia to enforce them. The challenge with any sanctions is their effect is limited without a path to negotiation. The recent sanctions will do little to change North Korea’s current strategic direction; particularly given that the country has been dealing with these kinds of restrictions for decades. Maybe the recent sanctions will make life a little harder for North Koreans, but they can survive as they have done in the past. They do not change the North Korean’s strategic calculus for the need for nuclear weapons.

In our previous interview, you mentioned China may not have the influence over North Korea that it used to. Is there potential for China’s role to change?

JT: There is a mistaken belief among the informed public that China has a level of influence on North Korea and Kim Jong-un in particular, because of North Korea’s economic dependence on China. But economic influence does not always translate to political influence. The relationship between China and South Korea is a good example; China is South Korea’s largest trading partner and they tried to use their economic leverage to prod the South Koreans to reverse the decision to deploy the THAAD ballistic missile defense system (a joint military program with the United States.) Despite trade and travel restrictions imposed by Beijing, South Korean officials kept the THAAD program on track.

It’s helpful to remember that the Chinese and Korean people have had relations going back centuries. From the Korean perspective, China has always loomed large over the peninsula and they have always sought to minimise Chinese influence and resist being absorbed into the larger state. The North Koreans know how to play the big powers off of each other and not to be dependent on any one of them.

In regards to the US, North Korea would only negotiate with a proxy country if they knew that country had some degree of control or influence with the US. But the idea that the US would delegate diplomatic objectives for North Korea to a proxy country, especially a country like China that has a significantly different world view, is misguided.

At this point, what is the likelihood of resuming negotiations?

JT: We see that it could go either way. There are calls from some Washington politicians for more negotiations, while others want more isolation. Opinion is clearly more divided now and Trump’s “war of words” has only strengthened resolve on both sides of the debate.

The best way forward in our view is for all parties to start using negotiations as a tool of diplomacy. Because of the current political tensions and high mistrust on both sides, the US can neither just jump into talks with North Korea, nor can it afford to wait for a “magic moment.” Hopefully, an opportunity to begin informal back-channel discussions will open up in the near future.  But if we continue down this course of increasing pressure on North Korea and Pyongyang responding by being more provocative, we are headed down a very dangerous path.

Without negotiations to create these diplomatic off-ramps and begin working actively toward achieving our objectives, this tense situation is certainly not going to get any better. And the last thing anyone really wants in an outbreak of war in Asia.

 

From an investment standpoint, markets across the region have been resilient. South Korean stock markets have slipped with the spike in tensions, but the KOSPI Composite Index remains up 16% for the year-to-date. Moreover, S&P just re-affirmed the Republic’s credit rating and the won has strengthened against the USD since the beginning of the year.

We asked Ed Wiltshire, Portfolio Manager for emerging market and Asia/Pacific equities, to share his view on how major markets in the region are holding up as geopolitical tensions continue.

Are investors in South Korea downplaying the risks?

Ed Wiltshire: The South Koreans seem surprisingly sanguine about these developments, but it must be remembered they have been living with the threat of their belligerent neighbour for many years. With Seoul and environs only 35 miles from the North Korean border and home to about half the country’s population, Pyongyang has long had the conventional weaponry to devastate its southern neighbour. So the stakes were already pretty high even before the North started their nuclear programme. 

In a sense, the latest developments are more of an issue for the US than their South Korean allies. This is why President Moon Jae-in has attempted to take a more measured course with the North, emphasising his continuing desire for dialogue rather than issuing threats. It’s true that when Trump and Kim Jong-un were making their most inflammatory statements, the equity market did sell off. But this was in the wake of a seven–month rally and, given how swiftly the market recovered, suggests that many investors saw it as an excuse for some long-delayed profit taking. And while the index measuring volatility in the South Korean equity market did spike at that time, it has now fallen back to being lower than the average over the last five years.

If the situation does escalate beyond words and sanctions into military action, clearly the South Korean market will take a big hit. But it is difficult to see any such scenario that doesn’t impact all markets in the region, and doesn’t involve the biggest global economies of US and China. The involvement of the US and China may ensure that the stakes are too high for any move away from the status quo.

Putting the North Korean situation to one side, recent developments in the South with respect to probable reform of the large conglomerates that dominate the market are very positive for the international investor. Political intent with regard to cleaning up the companies has been clear ever since the impeachment of the last President for her part in a cash-for-influence scandal. The recent five-year imprisonment of the chief of Samsung, South Korea’s largest company, for bribery has only served to underline this. If investors can accept the geopolitical risks, South Korea remains one of the most undervalued and potentially attractive equity markets in the Asian region.

What about trade between the US and South Korea? Is the potential for US protectionism and scrapping the Korus free trade agreement (FTA) a greater concern for South Korea?

EW: While discussion of the Korus FTA (between the US and South Korea) has begun, this is still in the ‘talks about talks’ stage. The US is South Korea’s second biggest trading partner (and South Korea is the seventh biggest for the US), so Seoul clearly has much to lose if Trump’s actions match his campaign rhetoric. But so far they haven’t, and Steve Bannon’s recent removal as Chief Strategist in Trump’s administration suggests the protectionists in the White House appear to be in descent. It seems unlikely that at a time when the US is trying to build consensus to oppose the North Korean nuclear programme they should choose to pick a fight over trade with their most important military ally in the region. And any weakening of US ties to the region would almost certainly be to the benefit of China. Again, this may be an example of tough talk used to disguise minimal action.

China is also an important economic player with relations on all sides in this conflict. How would you see rising geopolitical risks impacting China’s markets and economy?

EW: It’s hard to believe China is comfortable with North Korea developing nuclear weapons and destabilising the regional balance. Their main concern has always been to ensure that they don’t have a unified US-armed Korea on their border. However, their sway over Kim Jong-un seems significantly less than that over his father, with contact between the governments less frequent than had previously been the case.

The Chinese authorities continue to maintain a delicate balance between economic growth and reform measures to curb debt, particularly in the lead up to the 19th National Congress of the Communist Party this coming October, which should further consolidate President Xi’s power. North Korea is a distraction they don’t need, but in terms of risks to the Chinese economy, it remains quite low down the list. Indeed, it may actually have proved beneficial in the bigger game of US-Chinese relations in that Trump may be forced to hold back on his threatened anti-Chinese trade measures while he needs Beijing’s help in putting pressure on North Korea.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 5th September 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/1126/31122017