INSIGHTS


Dear Investors,

The Korean peninsula has garnered significant press attention in recent weeks. In a series of events that would not seem out of place in a Hollywood blockbuster: North Korea fired a series of ballistic missiles into the Sea of Japan, Kim Jong Nam—Kim Jong Un’s estranged half-brother— was assassinated by VX nerve gas in Kuala Lumpur, and to top it off South Korea’s constitutional court voted unanimously to remove President Park Geun-hye from office. Given increasingly belligerent moves from the North and turbulent political times in the South, how can foreign investors get comfort with the security situation on the Korean peninsula? We spoke recently to a number of former government officials, diplomats and economists familiar with the matter to hear their views.

 

First things first: What is THAAD and why is China so mad about it?

The Terminal High Altitude Area Defense (otherwise known as THAAD), is a U.S ballistic missile defense system that has the ability to intercept and destroy ballistic missiles during its terminal phase of flight. On March 7 2017, the US announced the deployment of THAAD in South Korea, in an effort to defend the US-South Korean alliance against growing North Korean missile threats. “Coincidentally” the announcement came one day after North Korea launched four ballistic missiles, supposedly in retaliation to the Foal Eagle military exercises carried out between South Korea and the US.

While the US maintains that THAAD is purely a defensive system to help South Korea protect itself from an attack, China suspects an ulterior motive which is to detect China’s own strategic missile activities and give the US an advantage in any potential conflict. China views this as a direct threat to its security and a means of undermining the delicate balance of power in the region.

 

How likely is a major conflict on the Korean Peninsula?

Unlikely. Any sort of armed conflict would destroy the North Korea’s regime’s ability to hold on to power, which at the end of the day is its ultimate aim. Stability and ensuring the Kim family remains at the head of government are the overriding priorities for the North, brutally evident by the countless executions and purges of senior officials as well as family members. Furthermore, the South Korean army, backed by the threat of US involvement, has much more effective and advanced armed forces. Any initial gains seen by the North would be more than offset by the likely overwhelming defeat in all-out war.

Another important factor is the sizeable economic chasm between the two countries. War is ultimately an economic activity, as one former South Korean minister put it, and the country’s ability to outspend its neighbor to the north is supported by the fact that the South’s GDP is estimated to be over 40 times the size.

Should the North take actual provocative steps, there is little incentive for the South to engage in a full fledged response. The reunification costs would be astronomical as the differences between the North and South are too large in terms of citizen views and knowledge of the world and the ability to integrate into the global economic system.

And finally, the deterrent of US involvement and wider global condemnation cannot be downplayed. The Americans, along with the UN, provide a security umbrella that sees nearly 30,000 US troops protect the Demilitarized Zone (DMZ) and the deaths of any troops stationed in South Korea would be a de facto declaration of war by the North on the US and the UN.

Therefore, it is likely that a continuation of the status quo will prevail. Usually, this follows a predictable stalemate in which the South realizes it is not in its interest to invite conflict as the North’s periodic outbursts will only lead to the typical small-scale skirmishes. Full-scale conflict is also not in the DPRK’s interests, as it too realizes, so a tense but restrained relationship between the neighbors seems likely to continue.

 

Should investors be worried about economic retaliation from China over THAAD?

China has shown its displeasure of THAAD through a series of economic retaliations from barring K- pop stars from entering China, to banning Chinese travel agencies from selling tour packages to South Korea. It is important to remember that these actions, though worrisome for South Korea, are in large part symbolic. In fact, economic sanctions or tariffs on the real heavyweight Korean exports to China (such as electronics or automobiles) seem highly unlikely given these would also see China’s economy suffer.

The reality is that today’s global supply chains mean that China and South Korea’s economies are tightly integrated. The Chinese are big fans of Korean products and Korea continues to channel a large portion of its foreign direct investment into China. We have also seen this movie play out before with Japan in the wake of Prime Minister Shinzo Abe’s controversial visit to the Yasukuni shrine in 2013. Each time there is a flare up in Sino-Japanese relations, Chinese consumers call for a boycott of Japanese products only for the fervor to die down after a few months.

Also, lest we forget that President Xi Jinping appeared at Davos earlier this year as the world’s unlikely champion of free trade. Any hint of protectionism or economic mercantilism on China’s part would discredit the government and undermine its soft power base in the region – something it has long been looking to accumulate. The bottom line is: we anticipate some short-term volatility, but over the long- term we expect tensions and markets to normalize.

 

How does Kim Jong Nam’s murder alter the dynamics?

Kim Jong Nam’s assassination in a Malaysian airport fits a pattern of regimented and systematic executions and purges that have been carried out on behalf of the Kim regime. North Korea’s Ministry of State Security is believed to be behind the latest killing, along with a host of others that have included Jang Song Thaek (Kim Jong Un’s uncle). Ironically, Kim Won-hong the former chief of the MSS and Kim Jong Un’s right hand man, is now under arrest and slated to be executed – evidence that no one in the regime is safe except Kim himself.

However, this incident is the first time that a North Korean leader has killed his own brother in an effort to eliminate a potential rival to the Baekdu bloodline – the moniker given to blood descendants of the first North Korean leader Kim Il Sung. To complicate matters, Kim Jong Nam was living in Macau and nominally under Chinese protection. He has been viewed by some as China’s potential leverage against the hermit kingdom’s despot leader.

This begs the question: How will China react to this blatant disregard for international diplomatic norms? And will China feel compelled to ratchet up sanctions on the regime?

 

The China Factor

While the UN Security Council has unanimously voted to impose UN resolution 2270, the toughest sanctions yet against North Korea, the effectiveness of these efforts will rely heavily on China’s cooperation which it has been reluctant to provide in the past. China has its own reasons to be wary of a North Korea regime collapse. A collapse and subsequent reunification could potentially see millions of refugees flooding into China, along with thousands of US and South Korean troops dangerously close to its borders, compromising China’s national security and sovereignty in the region.

Depending on which statistics you read, China accounts for anywhere between 70 to 90% of North Korean exports with coal being the number one commodity. China announced on February 18 that it would ban coal imports from North Korea in a move that indicated mounting discontent with North Korea’s behavior. However, China has imposed sanctions before only to cite loopholes that allowed exports of coal for “livelihood” purposes, so it remains to be seen how strictly they are willing to enforce the most recent ban.

North Korea is also highly dependent on China for its oil imports. Should China choose to suspend its supply, this would mean the DPRK’s tanks, armored personnel carriers, trucks, and virtually all military and transportation sectors will grind to a halt.

 

Where does South Korea go from here?

South Korea is set to elect its next President on May 9th 2017 to replace ousted leader Park Geun-hye from the ruling conservative party. Park took a hardline stance against North Korea and was a strong proponent for the speedy deployment of THAAD. The front-runner to succeed Park is Moon Jae-in, a member from the Democratic Party, who advocates pursuing dialogue with North Korea rather than sanctions.

In the short run, South Korea has no choice but to rely on U.S. nuclear capability as a deterrence as it does not have its own. However, a patina of stability could be achieved if Moon decides to revert back to the ‘Sunshine Policy’ when dealing with the North. This idea was based on encouraging interaction between the two while also offering economic assistance to the North.

Based on past form, a thawing of relations between the two seem likelier under a left-wing government while confrontation and sanctions are part of the standard template for dealing with the regime under a right-wing one. Given the left-leaning Moon, we should expect a détente of sorts. Moon has even suggested a review of the THAAD deployment arguing that any benefit from THAAD would be overtaken by China’s hostility towards it, making China less likely to lend their support to help manage Pyongyang.

Against this backdrop, investors can take advantage of short term opportunities which may open up due to near term impact on sentiment and profitability due to political developments, which can present good buying opportunities for PE. However, in the longer term we expect the base case is normalization back to the status quo.