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By Samuel Lum, CFA

With Kim Jong-un declaring that North Korea has entered a state of war with South Korea — not to mention cutting off a military hotline, threatening nuclear strikes, and shuttering Gaeseong, the joint North-South industrial complex — geopolitical tension in the Korean peninsula has been top of mind for global investors, especially those with a stake in the region. Events have been unfolding quickly. Earlier this week, the North Korean foreign ministry rejected overtures from the Obama Administration and U.S. Secretary of State John Kerry, who was in Asia last weekend and is seeking to defuse a potential nuclear crisis while also working to avoid rewarding North Korea for its bellicose behavior.

Meanwhile, South Korea’s KOSPI Index has dropped 4% since the end of March. With foreign investors fleeing, the valuation of the country’s benchmark index now checks in at one times net assets, compared to 1.5 for the MSCI Asia Pacific Index — the widest gap on a monthly basis, Bloomberg reported yesterday, since March 2007.

Attendees at the CFA Institute Korea Investment Conference last June may have seen the confrontation coming. At the event in Seoul, Brian Myers, a contributor to the Atlantic and the New York Times, as well as the director of International Studies at Dongseo University in Busan, made the following prediction:

[Kim Jong-un] has got to keep flexing his muscles, firing missiles, earning military victories over the enemy. The problem is that he’s already induced a kind of missile fatigue in his people. They are tired of that kind of thing. So everything needs to be bigger and better. So there is a very high danger, in the short term, of him engaging in some kind of serious provocation of South Korea. And I believe that at some stage, in the near future, in next five years, he is going to go too far . . .

(Myer’s full presentation is also available online, along with commentary from Professor Chung Min Lee, dean of the Graduate School of International Studies at Yonsei University in Seoul.)

So what does Kim Jong-un have in mind?

Over the years, rulers of the Democratic People’s Republic of Korea (OTC:DPRK) have resorted to military-first politics (known in Korean as Songun Chongch’i), as well as provocative rhetoric and gestures designed to create geopolitical tension in the Korean peninsula that can be used as leverage to gain concessions in international negotiations. According to Myers, who wrote The Cleanest Race: How North Koreans See Themselves, the heart of the DPRK regime’s ideology is “paranoid racial nationalism,” adapted from Japanese fascism that thrived between the two world wars, which has sustained the regime even as it has failed to provide its people with the economic prosperity that it has promised.

In a recent interview with China Review News Agency, Myers stressed that the DPRK’s posture is that if South Korea or the United States were to initiate military action in offense, the country’s military would fight back aggressively in defense. Myers says he regrets that the media tend to truncate the first part of that statement and have not been thorough in reporting the North Korean posture. He also points out that the DPRK has clearly indicated that it is ready to give up nuclear weapons when all countries owning nuclear weapons disarm as well (the veracity of that policy position remains to be seen, of course).

Ironically, Myers says that the North Korean economy actually occupies an important position in the country’s tightly controlled public agenda: In recent times, the official state-run news channel has led its broadcast with an economic focus before turning to the “war” rhetoric that is more aligned with the military-first policy. Yet to point out that North Korea is an economic basket case would be an understatement. GDP and GDP per capita are only around $40 billion and $1,800, respectively, in purchasing power parity terms — as compared to estimates of $1.6 trillion and $32,000 for South Korea. Economic growth has been in the low single digits or negative in most years over the last decade, and chronic food shortages render the DPRK perennially dependent on foreign food aid.

Next to the United States, China plays the most important role in the events unfolding on the Korean peninsula — much more so these days than either Japan or Russia. The DPRK is quite dependent on China, its largest trading partner, which supplies around 50% of the country’s imports and takes in about 25% of its exports — and has traditionally supported the North Korean regime on the world stage. With new leadership in both China and the DPRK, debates in China about its North Korea policy are underway, especially in light of the recent rhetoric around missile tests. While Kerry’s visit to China over the weekend did not result in any specific cooperative agreements, President Xi Jinping had denounced attempts to harm the region’s stability earlier this month at the Boao Forum and hinted at a possible change in policy.

Notwithstanding the recent tensions, Bloomberg reports that South Korea’s pension funds have been buying domestic equities on the dip, betting — as a spokesperson for the National Pension Service, the biggest institutional investor in Korea, put it — “that the impact on sentiment will be temporary and the frosty relations would thaw again going forward.”

For many investors seeking to decode North Korea’s behavior and its impact on markets, there are no easy answers. These resources may help:

When Kim Jong-un first took over as North Korea’s leader in early 2012, hopes were high that the DPRK would make a foreign policy U-turn. Recent events suggest otherwise. While the general view, particularly among South Korean investors, is that the North’s latest wave of belligerence will fade, as it has in previous episodes, no one can say for sure.

Meanwhile, investors in the region must grapple with the uncertainty: Is North Korea’s sabre-rattling truly an investment risk? Or for those with a longer time horizon, is it a buying opportunity?


Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: North Korea Nuclear Threat: Buy On The Dip?