Brinkmanship on the Korean peninsula - Nomura

Analysts at Nomura explain that tensions between North Korea and the US have, in their view, reached elevated levels unseen since September 1994, when the Clinton administration considered air strikes on North Korea’s main nuclear facility at Yongbyon.

Key Quotes

“23 years later, North Korea claimed that it successfully tested intercontinental ballistic missiles (ICBM) in July 2017. Tensions then escalated quickly before showing some signs of a temporary cooling during the week of 14 August. South Korea and the US are scheduled to hold a large-scale joint military drill from 21 August. Thus, another spike in tensions is certainly plausible and, unless there is some resolution, tensions could remain elevated for some time. Against this backdrop, we perform a deep dive into scenario analyses of macro and market reactions over the next 12 to 18 months. A range of geopolitical outcomes is drawn heavily from Alastair Newton, co-founder and director of Alavan Business Advisory, a geopolitical consultant to Nomura.”

“Alastair concluded that a continuation of the current trajectory for the next 12 to 18 months is the most likely (60% probability) scenario. In his other three scenarios (40%), a real crisis point is reached more quickly, with a roughly even split between manageable and bad outcomes. Alastair Newton’s breakdown of ten sub-scenarios speaks volumes about the degree of uncertainty faced in the Korean peninsula and by the administration in Washington. However, this is not to say that we are inevitably doomed to war. The risk is certainly there and it is non-negligible. However, adding together the sub-scenarios that Alastair believes avoid a war relative to those that involve it, the former seems marginally more likely than the latter.”

“Because a military confrontation could lead to the deaths of hundreds of thousands of people, we believe South Korea’s government will do “whatever it takes” to avoid war. In a forceful speech on 15 August, South Korea President Moon vowed to prevent war at any cost. In the meantime, we believe South Korean policymakers will strongly endeavour to calm market volatility, as the economy has a strong external balance and the government has a solid fiscal position. We set out three scenarios:

• Base case (tensions stay elevated for some time, but do not get out of control): We maintain our bearish view that Korea’s GDP growth will slow to 2.3% in 2018 from 2.7% in 2017 and 2.8% in 2016. The direct negative impact on South Korea’s economy will likely be limited to the tourism sector. We also anticipate some indirect negative impact on private consumption and construction investment from tighter financial conditions. We expect flexible FX policy, stimulative fiscal policy and a delayed normalisation of monetary policy (25bp rate hike in H2 2018).
• Good case (negotiation and resolution): This represents an upside risk to our economic outlook, as tensions between China and South Korea over the THAAD missile system would be resolved as a part of the negotiation. Also, financial conditions would become more favourable to growth as the geopolitical risk premium could fade. We believe FX and fiscal policies will be the same as in the base case, because South Korea policymakers will wait and see the how the actual negotiations conclude – which may take quite long time. However, in this scenario, the BOK could hike the policy rate sooner than we envisage in our base case.
• Ugly case (military confrontation): This would result in a massive blow to market confidence and South Korea’s economy due to the potential for a retaliatory strike by North Korea. This could lead to hundreds of thousands of deaths, even if nuclear weapons were not used. This would also significantly disrupt trade and production and result in a rapid contraction of domestic demand amid very high cost-push inflation due to supply shortages and higher import prices. Military confrontation would mean the end of North Korea’s regime and suggest an eventual reunification of the two Koreas, in our opinion. We envisage what the South Korean government can legitimately do under this scenario, including martial law (Article 77 of the Constitution of the Republic of Korea), capital controls (Article 6 of the Foreign Exchange Transactions Act) and BOK emergency monetary policy (Articles  65, 75, 76 and 90 of the Bank of Korea Act).”