Markets have discounted the “rocket man” risk, which has allowed Korea’s CDS to plummet, reunification-themed stocks to enjoy stellar returns, and prompted credit agencies to downgrade DPRK-related risk. This is premature. At the Singapore summit, Donald Trump plucked the low-hanging fruit in DPRK nuclear negotiations. Further progress will require a leap of faith from Kim or asymmetric security concessions from Trump. Neither seems likely. We do not expect Pyongyang to compromise on regime security, nor will the US President cave in on sanctions. Meanwhile, China is reasserting itself on the peninsula and will drive a hard bargain in any future negotiations, while the South Korea-US alliance is exhibiting cracks, undermining the regional security apparatus. Future volatility in Korean assets is likely, which could exacerbate wider EM risk-off sentiment.
The Singapore summit agreement is unravelling as “soft” concessions run out. The stock of non-significant concessions available to either side is being exhausted. There can be only so many state visits, economic initiatives and family meetings. On the military front, DPRK denuclearization moves have been token at best. High-profile actions, international press visits and the dismantling of some redundant military sites, notably the Tongchang-ri missile engine test centre, are all small reversible measures. Meanwhile, indications of continued missile and nuclear activity highlight a lack of clear progress towards denuclearization. Satellite-image analysis has discovered at least 20 undeclared missile bases. Further reports indicate that rocket and fissile material is being moved to sites around North Korea, not being destroyed. Trump interprets the lack of missile tests as evidence he is “winning” and waves aside the new information on missile bases. How long he will remain content with superficial progress in order to claim the Singapore meeting as a huge personal success remains to be seen.
Xi Jinping sees the trade war and North Korea as related issues. The understanding Chinese officials took from the Trump-Xi Mar-a-lago meeting in 2017 was that Beijing would persuade Kim to take part in a summit and, in return, the US would ease trade pressure on China. Having upheld its end of the bargain, Beijing feels aggrieved that its economic and diplomatic pressure on the DPRK has not been recognized by Trump. As his G20 meeting with Trump approaches, it is in Xi Jinping’s interest to encourage a controlled escalation of tension, which would allow China to resume its position as chief DPRK handler. The price for bringing Kim to the negotiating table again will be much higher a second time round.
Beijing reasserts itself on the peninsula. As US-China tension has increased, Xi Jinping has moved to bring China and North Korea closer. Kim has visited China three times in one year, an unprecedented number of visits for a DPRK leader. Moreover, anecdotal reports indicate that Beijing is reinstating economic support for Kim. Food aid under humanitarian grounds has increased, while Chinese flights and tour groups are once again permitted to land in North Korea. Personnel exchanges have picked up recently: North Korean Deputy Minister of Defence Kim Hyong-ryong attended the Xiangshan security forum in October and Yao Ming, of NBA fame, headed a sports and friendship delegation to Pyongyang. We expect Xi and Kim to continue efforts aimed at improving economic and diplomatic ties. The tighter the China-DPRK alliance appears, the stronger the negotiating position for Xi on trade and for Kim on sanctions.
Kim will not gamble with regime security. We believe North Korea is approaching a point where the regime perceives its security as threatened by further demilitarization. Thus far, Pyongyang has been able to destroy unimportant elements of its military apparatus, fostering the illusion of progress. The DPRK is militarily and economically weaker than its neighbours by many orders of magnitude. Pyongyang knows a misstep could cause regime collapse; Kim has the examples of Libya and Iraq in mind. As the DPRK approaches the point where it sees each increment of disarmament as further undermining regime security, it will be increasingly unwilling to demilitarize. US demands for a complete list of nuclear facilities signal a rapid approach to this precipice. The publication of such sensitive information without first receiving security or economic guarantees is untenable for Kim. This is one of the reasons for the recent hardening of North Korean attitudes, which resulted in the cancellation of Mike Pompeo’s latest planned visit, and increasingly strident rhetoric from Pyongyang, as it calls for a peace treaty to bring a formal end to the Korean war.
White House flexibility will determine whether negotiations are to continue. Given Pyongyang’s security constraints, it will be the extent of Trump’s willingness to give ground on sanctions or US military issues, prior to material denuclearization that will decide whether or not negotiations are to continue. The risk-reward profile is such that the US could make the first major move without undermining its geostrategic position. If the DPRK responds, as it has done historically, by refusing to denuclearize further, the US will have lost face, but nothing more. However, President Trump has not shown the slightest inclination to make free concessions in any of his on-going trade or geopolitical negotiations, although he has in the past acceded to agreements (perhaps without full knowledge of their significance) that were accepted by North Korea as a sign of good faith. His announcement in Singapore on halting joint US-ROK military exercises is a prime example. It remains unlikely that Republican hawks will allow Trump to go as far as withdrawing US forces from the peninsula, restricting reconnaissance over North Korea and providing public security guarantees to the regime. Without US concessions to move forward negotiations, a return to the “fire and fury” of the early Trump Presidency is possible.
South Korea vulnerable to “fire and fury”. Before the 2016 US presidential election, markets were essentially inured to DPRK-related risk. Our proprietary data set covering the last 10 years of North Korean military provocations shows that the average market move in response to a nuclear missile test was a 0.5% weakening in KRW/USD, a 10% spike in KGB 5YR CDS and 0.5% fall in the KOSPI. In 2017 Trump’s “fire and fury” warning caused a 2% decline in the Won, a 20% jump in CDS and a 3.5% fall in the KOSPI as he significantly elevated market perception of DPRK risk (see Charts 2 and 3 above).
Since the Singapore summit, this risk has been discounted again. A breakdown, or even pause, in talks and a return to early Trump term sentiment will be most evident in the Korea CDS market, which is now at 10-year lows (see Chart 1 above). KOSPI construction stocks, which investors expect to benefit from a North Korea infrastructure boom, have rallied more than 100% since the Singapore summit, are highly vulnerable to any negative DPRK outlook too. Beyond the headline impact on stocks and bonds, the ramifications for EM Asia sentiment could be severe. If the return of North Korea risk coincides with an escalation of the US-China trade war, the Korea factor will magnify risk-off sentiment and broader EM outflows.
Since the Singapore summit President Moon has been the lead actor driving political and economic relations with the North. He has met Kim three times and fostered accelerated Korean integration and demilitarization. His enthusiasm is no surprise: the President and his political mentor, Roo Moo-hyun, are synonymous with the “sunshine policy” of engagement. As Moon comes under increasing domestic pressure as a result of failing domestic economic reforms, we expect the President to accelerate his push for greater North-South integration, regardless of actual denuclearization progress. Although Moon is too canny to be caught openly contradicting Washington’s position, differences of opinion with the US will surface, which, unless carefully managed, could jolt the alliance.
Rifts are already emerging over inter-Korean economic support. In his efforts to provide sanctions relief, Moon has stretched the definition of humanitarian aid to the North to the limit. Last month, Kang Kyung-wha, the foreign minister, went too far by raising the possibility of lifting some of RoK’s unilateral sanctions on the North; in a swift response, Trump shot back that he “would not allow Korea to lift sanctions”. Further dissonance between these allies is likely. Should the US openly curtail South Korea’s engagement with the North, a public backlash would significantly weaken Moon’s domestic political position and damage the denuclearization process.
Policies are diverging as the US-RoK security alliance is undergoing a delicate evolution. Moon is also pushing for greater South Korean autonomy in military affairs. In October the US reluctantly agreed to grant South Korea wartime operational control of Korean forces. Currently, the US four-star general of the RoK-U.S. Combined Forces Command has authority over the manoeuvres of both U.S. and South Korean troops during wartime (South Korea retrieved its peacetime operational control in 1994). If US-RoK differences continue to widen, Moon, who in his youth campaigned against the US military presence in South Korea, will accelerate the push for greater military autonomy – to the benefit of both Beijing and Pyongyang.
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