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LIM Soo-Ho

North Korea and Markets’ Risk Tolerance

LIM Soo-Ho

Apr. 19, 2012

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When North Korea conducts a long-range rocket test one of the few certainties is that financial markets in the South will be less concerned than foreign watchers. The launch of the Unha-3 rocket on April 13 was no exception. The benchmark KOSPI rose, just as it did when the Unha-1 and Unha-2 were sent skyward in 1998 and 2009, respectively.

Fortunately, the threats from North Korea have had very limited impact on the Korean economy thus far. This is because the economy has become that much larger, and the variables affecting the financial markets have become that much diverse. In particular, built-up tolerance and accumulated learning experience have created an emotional buffer.

Even if the Unha-3 rocket was successful the markets would have been expected to react with hardly more than a shrug. The fact that the Unha-3 rocket shattered only a few minutes into its flight more than an hour before financial markets opened, only deepened the indifference.

Of course, the market's tolerance cannot be taken for granted in all cases. The game changer is the perceived seriousness of the North's provocation. In the case of rocket launches disguised as satellite launches, even if the North's true intensions are to develop long-range missiles, Korean citizens and investors have a tendency to not regard it as a threat to national security.

On the other hand, declared missile tests such as the long-range Taepodong-2 missile launched in July 2006 was considered direct security threats. Likewise, the North's withdrawal from the Nuclear Non-proliferation Treaty (NPT) in January 2003 was perceived as strategic move that raised the potential risk of a nuclear arms race. These events unnerved investors and the stocks fell for a short time within a narrow band. Of course, direct military confrontation will rattle the most jaded investors. When the North suddenly launched an artillery barrage on Yeonpyeong Island in November 2010, the first attack on civilians since the 1953 Korean War armistice, anxiety in the financial markets understandably soared. The KOSPI plummeted by over 30 percentage points and took more than a week to stabilize.

Timing is another key when predicting the stock market's reaction. If Pyongyang signals its intentions well ahead of an event, the market has time to assess and digest an escalation of tensions. By the time a provocation occurs, it has had time to be baked into stock prices. Also, if other newsworthy events are occurring, it can dissipate the impact of the North's plans. The North's announcement about its Unha-3 rocket launch and follow-up commentary in the South was largely smothered by the run-up to the National Assembly elections. Consequently, financial markets were more riveted on the potential impact of the elections on economic policy.

The time cushion, however, is removed if there is series of provocations or if tensions are prolonged. For example, the second nuclear test in May 2009 had little impact, but the short-range missile launch that immediately ensued and the international community's firm response, resulted in stock prices taking a nose dive.

What does this all mean? Due to countless repetitions of provocation and dialogue, investors have learned to expect that tensions will subside quickly and any sharp decline will be brief and followed by a V-shaped recovery. However, if the pattern of the threat differs from those in the past, expectations for a quick resolution or return to stability are eliminated. This can send investors rushing to the exit doors. The same market wariness would be expected if the international community wields its stick and the situation becomes protracted.

As such, Seoul officials must perform a delicate balancing act of responding firmly to North Korean provocations but acting with a cool-headed demeanor, knowing that financial markets and the international community will be looking to them for direction. Obviously, maintaining stability is paramount. Provocations thus are handled as isolated incidents to avoid escalation and to normalize conditions.

Although last week's rocket launch passed without much incident, future provocations, which have increased in strength and frequency since 2009, are expected. If North Korea repeats its past pattern of following long-range rocket launches with nuclear tests, this time blaming the U.N. Security Council's condemnation of the launch, investors can expect a market decline because of the perceived direct threat. But, it is important to remember that the Korean economy has the sufficient means to endure the impact and overreacting could have undesirable consequences.

This column originally appeared in Korea JoongAng Daily.
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