Pyongyang Bomb Rattles Korean Stocks

Three-years of six-party talks with Pyongyang simply led to North Korea’s detonation of a nuclear bomb on October 9th, 2006. It’s no secret that North Korea has a small arsenal of nuclear weapons, but it was a bit of a surprise to see Kim Jong-il actually pull the trigger.

China has been North Korea’s main supporter, since the Red Army saved it from defeat by US forces under a UN flag in the 1950’s. Beijing provides 90% of N Korea’s oil supply, estimated at one million tons per year. But this time, China might have overplayed the North Korean card. The specter of an Asian atomic arms race now looms over the region, and Beijing could find itself surrounded by neighbors in Japan, South Korea, and Taiwan moving to join the elite club of nuclear powers.

Japanese Prime Minister Shinzo Abe, a staunch North Korea critic, wants to amend the Constitution to give Japan’s military greater leeway to go nuclear, and it won’t take long to convert its huge stockpile of plutonium. South Korean Finance/Economy Minister Kwon O-kyu warned on October 10th, that foreign investors could flee from Asia’s fourth-largest stock market in the near future, as geopolitical risks involving North Korea are expected to further intensify. “If the UN Security Council and the US decide to take harsh actions against the Stalinist country, the negative effects on the Korean economy could worsen, prompting foreign investors to take money out of the country en masse,” Kwon said.

North Korean leader Kim Jong-il has called Washington’s bluff, betting that the crisis it has created by testing a nuclear weapon will bring pressure on the US to abandon its own refusal to deal directly with Pyongyang. But after a brief knee-jerk shakeout in the Kospi stock index to the 1300-area, Asian traders began betting on a diplomatic solution on October 10th, after Pyongyang offered to abandon its nuclear program, in return for financial and security guarantees from Washington.

Traders in South Korean stocks and the Korean won have prospered under the dark shadow from the North, since Pyongyang first disclosed its nuclear arsenal to the world in April 2003. The Korean Kospi index has doubled from 3-½ years ago, while the US dollar has plunged by 250-won, or 20%, during the same time period. In the past, sell-offs ignited by worrisome news from Pyongyang, were simply better buying opportunities at cheaper prices for foreign and local investors.

Korean Kospi blue-chips such as Kookmin Bank (KB), Shinhan Financial (SHG), Posco (PKX), Woori Finance (WF), LG Phillips (LPL), SK Telecom (SKM), Samsung Electronics [005930.KS] and the Barclay’s I-share for Korea (EWY), were hit hard by Pyongyang’s detonation of a nuclear bomb. On October 9th, the Kospi Index ended 2.6% lower at the 1,316-level, after tumbling as much as 3.6% earlier. The US dollar jumped to close at 964-won from 949-won, and gained 1.2% against the Japanese yen to 119.18-yen.

But tranquility prevailed in Seoul on the very next day, and the Kospi index recovered 0.6% to close at the 1328-level, after foreigner investors rescued the market with net purchases of 496 billion won, their largest one-day purchase since April 11th. The sudden interest in Korean stocks by foreigners was surprising, since they had sold a record 9.5 trillion won of Korean stocks between May and September, lowering their exposure by 5% to 38% of the market’s capitalization.

Despite the doubling of the Kospi index since 2003, South Korea’s top-30 capitalized firms sell at a price-earnings ratio of 15.5, much lower than the top-30 Japanese P/E’s of 53.5. The return on equity of the top-30 Korean firms was 16.9%, higher than the top-30 Japanese firms at 11.3%, indicating that Korean firms are making more profit from investment than their Japanese counterparts. But short-term Korean deposit rates are 4.25% higher than Japanese rates, and might account for the inflated value of Tokyo stocks.

Setting the nuclear threat aside, the Korean Kospi index has managed to climb a wall of worry for the past 3.5 years, thanks to booming exports to China. While exports to the US stagnated between $3 and $5 billion per month for the past four years, Korean exports to China soared from $1.5 billion in Feb ’02 to a record $8.2 billion in August 2006. In the first nine months of 2006, Korean exports totaled $238.62 billion, or 14.9% higher from a year earlier. Bilateral Korea–Sino trade was $61.9 billion in 2005, up 24% from the previous year.

And behind the scenes, the Bank of Korea [BoK] is tolerating a 9.2% annualized growth rate for its M2 money supply, the fastest gain in nearly 3-½ years, to buoy Kospi stocks and to counter US dollar weakness against the won. The BoK has lifted its overnight loan rate by 1.25% to 4.50% over the past year, but not high enough to slow borrowing and money supply creation. The BoK is expected to leave its loan rate unchanged on October 12th, to soothe jittery markets.

Pyongyang’s detonation of a nuclear bomb did knock the EWY from $48 per share to its key upward sloping trend-line, which resides this week near the $45 per share area. With explosive Korean money supply growth, booming exports to China, and surging global stock markets in the background, traders are betting that Beijing will reign in the mercurial Kim Jong-il, and buying EWY, with tight sell stops below $44.75 per share. To read more about Korean and global markets, click on the Global Money Trends link above.

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