Don’t ignore ‘North Korea Effect’

SEOUL - A new theory is making the rounds for what might precipitate a Japanese banking crisis: North Korea.

Here's the scenario. Pyongyang resumes missile testing in the months ahead. Next, it test-fires one over Tokyo, hitting the Nikkei 225 Stock Average hard.

Then, around mid-year, North Korea declares itself a nuclear power and says it is willing to use its bombs. The Nikkei plunges, taking Japanese banks, and the Asian economy, down with it.

While far-fetched indeed, the 'North Korea Effect' is increasingly working its way into markets around Asia.

The West may be preoccupied with Iraq, but those who ignore risks from North Korea could be hit on the blind side by declining Asian markets.

Things will get much worse if the 'North Korea Effect' hits Japan.

If the Nikkei plunges on geopolitical risks, Japanese banks would move closer to insolvency, worsening conditions in the world's second-biggest economy.

That would probably push the yen sharply lower, imperilling Asia's post-crisis recovery.

A diplomatic solution on the peninsula is more likely than a military one.

But with North Korea saying the peninsula will be 'reduced to ashes' if the United States further raises troop numbers, and US Defence Secretary Donald Rumsfeld calling it a 'terrorist regime', this is no time to ignore risks in Asia.

Last Friday, the won closed at a one-month low on speculation that overseas investors had shunned the country after the North threatened to launch a strike should the US continue to build up forces in the South.

Business confidence slumped to a two-year low last month because of a global slowdown and tensions over North Korea.

'Uncertainty in the external environment is increasing due to the possibility of a war breaking out between the US and Iraq and the tension over North Korea's nuclear programme,' South Korea's central bank said in a statement last Thursday.

While South Korean markets have reacted to threats from the North, some observers are surprised at how well they have held up. It may suggest rising tensions between Pyongyang and Washington have yet to be reflected in stock prices, bond yields or currency markets.

Mounting concern over the North Korean crisis has emerged as the biggest risk to the South's economy in the long run. It is quite a reversal of fortune for an economy that has had a good run these last few years.

If South Korean businesses scale back capital spending the way their US counterparts have since the Sept 11 attacks, the economy's outlook will change for the worse.

The same is true if consumers close their wallets.

Or what if foreign investors begin fleeing won-denominated assets? The resulting turmoil and increase in borrowing costs could do serious damage to South Korea's economy.

That would be an ironic reversal of fortune. In the five years since the start of the Asia crisis, South Korea has become a role model for the region's recovery efforts.

Yet investors increasingly perceive the risks. 'In Asia, everyone was heavy on South Korea,' says Mr Mark Headley, co-manager of the US$43 million (S$75.5 million) Matthews China Fund.

The dispute over North Korea's nuclear weapons programme and last year's 10 per cent decline in South Korean stocks have investors reconsidering their holdings. Stocks are down more than 8 per cent so far this year.

If that were not bad enough, further sabre-rattling by Pyongyang and Washington, or any signs of nuclear escalation, could have serious implications for Japan. A crisis in Asia's biggest economy is the last thing the region needs.--Bloomberg News