North Korea's Provocations and South Korea's Stock Market. LIM Soo-Ho

Transcription

1 Departments: North Korea Bulletin The announcement of the death of North Korean leader Kim Jong-Il caused the Korean stock and forex markets to stumble temporarily. This reflected concerns on the stability of North Korea among the financial community. Although impact was limited, there is still a need to understand the effect of North Korean security shocks on the South Korean markets through analysis of previous incidents. There have been numerous studies on the effect of North Korea s security-related provocations on movements in South Korea s main stock market. So far, there has been no consensus on a causal effect; some researchers argue that the relationship is statistically significant 1 while others argue otherwise. 2 North Korea's Provocations and South Korea's Stock Market LIM Soo-Ho This paper examines the relationship between security shocks from the North and the stock market reaction in the South through a systems thinking approach. Market reactions were placed in several categories to determine whether the market moved in proportion to the intensity of various shocks. To that end, 10 of the most severe provocations from 1998 to 2010 were gauged. In eight of the incidents the market moved in line with the shocks. In two cases, however, there was no proportional market fluctuation. To explain this, channels in which shock waves traveled to the market, shock absorbing factors, and shock amplifying factors were analyzed. Finally, this paper comments on what the analyses suggest. 1 Lee, K.Y.. (2006). The Effects of News about North Korea s Nuclear Weapons on Domestic Stock and Foreign Exchange Markets. Journal of Northeast Asian Economic Studies 18(1); Ahn, H.J., et al. (2010). The Effects of News Related to the Inter-Korean Relationship on the Korean Stock Markets. Journal of Korean Economic Analysis 16(2). 2 Nam, S.W.. (2004). North Korean Variables Influence on the Change of the Index of Stocks and Policy Suggestions. The Journal of Northeast Asian Economic Studies 16(1); Kim, C.W.. (2011). Inter-Korean Relations and the Korea Discount : an Analysis of Foreign Investor s Stock Trading. Unification and Peace 3(1)

2 LIM Soo-Ho Types of Stock Market Fluctuations This study considered North Korean provocations and the reaction of the main South Korean stock markets from May 1998 to December While there were numerous North Korean provocations outside of the time frame that jarred stock investors in the South, foreign investors did not have full access to Korean listed stocks until May 1998, creating a different scope for comparative analysis. Excluded from the study were cases in which the stock market opened three to four days later or those in which the situation was so prolonged that impact on the market cannot be verified. The amount of press coverage of each incident was used to measure the intensity of the shock to the stock market (P), which was calculated as (the number of news reports of each incident / the total amount of news coverage of the top 10 incidents) Shock intensities of less than 6 on the bellwether Korea Stock Price Index (KOSPI) were categorized as weak (P0), while those between 6-10 were classified as average (), and those over 11 were classified as strong (P2). Table 1 Provocations and Subsequent Market Shocks Intensity of shocks P0 2.2 (10th) Incidents Test firing of an improved Taepodong-2 missile (Apr. 5, 2009) Types of stock market reaction Degree of fluctuation (p) KOSPI movement Recovery period (day) Coefficient of variation (CV) R P0 3.5 (9th) Inter-Korean naval clash near Daecheong Island (Nov. 10, 2009) R P0 5.8 (8th) Test firing of a Taepodong-1 missile (Aug. 31, 1998) R (7th) Live-fire drills near Yeonpyeong Island (Dec. 20, 2010) R (6th) Second nuclear test (May 25, 2009) R (5th) First Battle of Yeonpyeong (Jun. 15, 1999) R (4th) North Korea s withdrawal from the Nuclear Nonproliferation Treaty (Jan. 10, 2003) R P (3rd) Test-firing of the Taepodong-2 missile (July 5, 2006) R P (2nd) Artillery shelling of Yeonpyeong Island (Nov. 23, 2010) R P (1st) First nuclear test (Oct. 9, 2006) R Note: 1. Figures in parenthesis in the Intensity of shocks column refer to the ranking of each incident. 2. The CV is the ratio of the KOSPI s standard deviation divided by the mean. The time frame for R0 s CV was from the day of the incident to the day before the incident while that for R1 and R2 was from the day before the incident to the day the stock market recovered. 3 The amount of new coverage is based on reports from the Chosun Ilbo. January 2012 SERI Quarterly 133

3 North Korea's Provocations and South Korea's Stock Market Stock market fluctuations were divided into three categories, based on the decline and recovery period of the KOSPI: a) R0 indicates no response or a slight rise; b) R1 indicates the index falling less than 30p and recovering within five days; and c) R2 indicates the index shed more than 30p and took more than five days to recover. Channels that convey shock to the stock market Noteworthy are the 2006 test-firing of the Taepodong-2 missile and the second nuclear test in In both provocations, the stock market did not fluctuate in proportion to the shock intensity of the events. Noteworthy are the 2006 test-firing of the Taepodong-2 missile and the second nuclear test in In both provocations, the stock market did not fluctuate in proportion to the shock intensity of the events. The market s reaction was mild (P2 R1) compared to the reaction of the South to the intensity of shock after the 2006 missile test. However, the market reacted noticeably to the second nuclear test. Assuming that there were shock absorbers and shock amplifiers surrounding the stock market, this paper did a caseby-case analysis through systems thinking. Test-firing of the Taepodong-2 Missile When North Korea test-fired its long-range Taepodong-2 missile on July 5, 2006, several mechanisms appeared to cushion the psychological impact on the public and investors, both domestic and foreign. First, inter-korean relations blunted a possible confrontation between the US and North Korea. US financial regulations on North Korea that began in September 2005 had made US-North Korea relations extremely precarious, with the possibility of US surgical strikes on North Korea being raised. Therefore, extreme tension could have been expected when serious North Korean provocations were reported. Instead, the impact was softened because the South Korean government acted as a buffer between Pyongyang and Washington

4 LIM Soo-Ho Figure 1 The Impact of the 2006 Missile Test 4 Second, the lead-up and outcome of the missile test cushioned the shock effect of the launch. There was media coverage of the Taepodong-2 missile being fueled (s_b2) two 4 In the figure, 1) + means the cause and result are in a proportional relationship while - means they are in an inverse proportional relationship. 2) R means a reinforcing feedback loop where variables positively affect each other to move in the same direction while B means a balance feedback loop where variables control each other. 3) Thick lines represent strong influence, thin lines represent weak influence and faded lines represent no influence. January 2012 SERI Quarterly 135

5 North Korea's Provocations and South Korea's Stock Market Figure 2 The Impact of the 2009 Nuclear Test weeks before the launch and the missile exploded about 42 seconds into its flight, easing worries about its threat capability (s_b3). Third, the test-firing was largely viewed as an attempt by the North to secure one-on-one talks with the US rather than for military purposes. In addition, speculation that the missile was designed to put a satellite in orbit rather than deliver a warhead mitigated security worries (s_b3)

6 LIM Soo-Ho The launch provoked similar reactions by domestic and foreign investors. It did not particularly rattle domestic investors (f_r1). Although they initially launched sales totaling 69 billion, they returned in force the first day after the missile test, for net purchases of billion. Foreign investors on the other hand reacted with massive sales (f_r2) but came back two days after the missile test, with net purchases of 56.1, lowering the impact to R1 from P2. Although the missile test provoked some calls in the US for a surgical strike against North Korea, the fact that the missile exploded in flight defused fears of a new, imminent danger. Second Nuclear Test in 2009 North Korea s second nuclear test on May 25, 2009, provoked an R2 stock price decline from shock. Like the 2006 missile test, there were shock absorbers present. When the nuclear test occurred, the atmosphere on the Korean peninsula was ripe for alarm by the public and investors. Both inter-korean and US-North Korea relations had been strained since However, the suicide of former President Roh Moo-hyun just two days before the nuclear test overshadowed North Korea s attempted provoca-tion. Although there was no lead-up time (s_b2) to reduce the shock in contrast to the 2006 North Korean missile test, both the Korean and US government showed strategic patience, responding coolly to the nuclear test, and diminishing the effects (s_b3). The North s announcement that it had nuclear weapons in 2005 and the first nuclear test in 2006 also established the fact that North Korea possessed nuclear weapons, so the South Korean public perceived the second nuclear test as a politically-motivated action aimed mostly at the US, rather than a new military threat. Although there was no lead-up time to reduce the shock in contrast to the 2006 North Korean missile test, both the Korean and US government showed strategic patience, responding coolly to the nuclear test, and diminishing the effects. Considering the shock cushions already in January 2012 SERI Quarterly 137

7 North Korea's Provocations and South Korea's Stock Market place, one would have expected R1 movement in the KOSPI. Instead, the immediate response from Seoul unraveled the effect of the buffers as South Korea officially joined the Proliferation Security Initiative (PSI) the day after the nuclear test. Up to then, the South had refrained from joining the PSI, fearing that it would undermine its relations with Pyongyang. Immediately after the PSI action was announced, the North test fired three short-range missiles into the East Sea. The tit-for-tat moves provoked overreactions by both domestic investors and foreign investors creating an R2 movement in the KOSPI. Before, the shock effects of North Korean provocations were short-lived. The 2009 nuclear test, however, was followed by a second provocation, suggesting that a vicious circle of provocation strong response additional provocation could form. This seems to have dampened the investment appetite of domestic and foreign investors. On the day of the nuclear test, the KOS- PI only shed 2.9 percentage points as net purchases by foreign and domestic private investors offset net sales by domestic institutional investors. However, the following day, with the PSI announcement and subsequent North Korean short-range missile tests, net purchases of foreign investors plunged amid continued selling by institutional investors, sending the stock market into a sharp dive. Prospects and Implications Based on the foregoing, the following conclusions can be drawn. First, when there are factors that can alleviate the impact or lead-up time for the public to absorb news of a provocation, even serious shocks will be muted, causing only a slight decline in the stock market. Second, if the impact is not very strong or there are alleviating factors or time to soften the impact, stock prices will plunge if a subsequent provocation occurs or a vicious circle of provocation strong response additional provocation is expected. When a shock is more serious than the public and investors expected from past experience, it may lead to the chain reaction of a stock market crash. Recently, fiscal deficits and concerns over another economic recession in advanced countries have increased, stoking volatility in the Korean financial market. Moreover, as North Korea is in a transitional period of power transfer, the strength and frequency of provocations against South Korea and the US are likely to escalate. Under these circumstances, a stronger-than-expected provocation or series of provocations by North Korea can prompt a grave stock market plunge (R3 type) that exceeds even the previous range of fluctuations. Accordingly, the South Korean government s role is critical. The government should attempt to keep inter-korean relations at least on a stable level, and if a crisis is triggered by North Korea, the South should make systematic efforts to blunt the impact with available means, including warning the public in advance when possible. Above all, the government should respond resolutely, and employ effective measures after an incident to prevent subsequent provocation and preempt a vicious circle of provocations and counter-measures. Translation: Yi Chiwon, OH Hae-Young Keywords North Korean provocation, South Korean stock market, systems thinking, shock absorbing factors, shock amplifying factors LIM Soo-Ho is research fellow at SERI. His current research focuses on North Korea and nuclear non-proliferation. He is the author of The Rise of Markets within a Planned Economy: a Forecast for North Korea's Economic Reform and System Change (SERI, 2009) and co-author of US-DPRK Confrontation (SNU, 2011). He holds a PhD in Political Science from Seoul National University. Contact: sooho.lim@samsung.com