In a piece last week for Goldman Sachs, “Korea Views: Elevating Geopolitical Tensions—This time may be different,” Goohoon Kwon and Irene Choi argue that while markets tend to dismiss geopolitical tensions on the Korean peninsula, this time may be different, specifically contributing to depreciation of the South Korean won. (Don’t ask for the hyperlink to the report—it’s a proprietary GS product and I think that you have to be a senior official in the Clinton or Cruz campaigns to get a freebie.)
First, Kwon and Choi are correct in their reading of past history. The impact of previous provocations such as nuclear and missile tests on stock market prices and exchange rates in both South Korea and Japan have been fleeting, generally disappearing within a week or so. Nor, for that matter, did the imposition of UN sanctions have any material effect on these economies.
They argue that this time might be different however for two reasons. First, because South Korea is reacting more forcefully this time around, closing the Kaesong Industrial Complex, and in the wake of the Yeonpyeong Island shelling the rules of engagement changed which facilitate a more rapid escalatory response. Second, because sanctions–undertaken multilaterally through the UN, and bilaterally by the US, Japan, and possibly even China–may be more effective this time. They estimate that North Korean balance of payments revenues, already expected to decline because of falling commodity prices, would fall further due to the closure of KIC and possible declines in revenues from tourism and the export of labor. They expect North Korea’s current account balance to worsen by $460 million in 2016, though the Kwon-Choi analysis appears to ignore offsetting declines in the price of imported oil, which I estimate may more than offset the decline in the coal price. They reckon that 60 percent of this decline (or about $276 milion) is due to sanctions (but provide no explanation for this claim) and assert that this is roughly 3 percent of North Korean GDP (again providing no further substantiation). This shock they believe is sufficient to slow down the North Korean weapons program.
From this they derive three scenarios: the first and highest probability scenario is in essence a continuation of the status quo: some sanctions are imposed but they are not sufficient to destabilize North Korea; in the second scenario, the sanctions are tougher; and in the third, which they regard as “quite unlikely” involves “localized military conflict” which they believe will be avoided because both sides know the risks. It is not clear how they get from these scenarios to the “this time it may be different” depreciating South Korean won outcome. Maybe it’s an increase in the risk premium. Maybe it is some direct macroeconomic impact. They don’t say.
The fact of the matter is that the won has been depreciating, but as Erik Weeks at the Treasury has pointed out, there are plenty of reasons for won depreciation namely weakening growth and central bank easing bias. When South Korea announced the closure of KIC, it didn’t trigger further won depreciation insofar as it was seen as a proactive South Korean move, and the importance of KIC to the South Korean economy in macroeconomic terms is less than trivial.
But buried in the GS report and its somewhat misleading title is a deeper truth: as I wrote back in 2011, “North Korea’s provocations appear to be doing more damage to its own economy than to South Korea’s.” The reason is actually simple: South Korea has a much more robust economy, so while North Korean provocations may impose some economic costs on the South Korean economy, in the past these have been small and transitory. In contrast, North Korea has a relatively weak economy with more fragile trade and financial links to the rest of the world. A shock that South Korea can shrug off can have real macroeconomic implications for North Korea as I demonstrated during that previous episode. The often alleged North Korean asymmetric capacity to wreak havoc with the South Korean economy actually seems to work in the opposite direction. As in shooting off one’s own foot.
A deeper question–with Kim Jong-un’s legitimacy increasingly associated with the economy and his capacity to generate growing economic benefits for key regime supporters and the donju class–is how his political fortunes could be affected by the boomeranging economic impact of the missile and nuclear tests. Perhaps it will be different this time. But I wouldn’t hold my breath.