When news broke late Sunday night that North Korean dictator Kim Jong Il had died, there was pretty much an instant sense of uncertainty and nervousness in Asian markets. The reason for this unease is not hard to ascertain; North Korea is a desperately poor country with a huge military. If the new leader, Kim Jong Un cannot quickly cement his power and authority, there is the threat and risk of civil war, military provocation against South Korea and/or Japan, and a continuation (or escalation) of the brinksmanship that Kim Jong Il used to keep world powers ill at ease. For Japan, it's all about that stability. Trade between Japan and North Korea is insignificant, but Japan does worry about the unpredictability of North Korea and the military threat it represents. Japan is not going to step up its military spending overnight because of this transition, but a more bellicose North Korea may well force Japan to reassess its needs; something it can arguably ill-afford, given its high debt and demographic problems.
What will this change in power mean for the markets, both in Asia and in the United States?
TUTORIAL: Economics Indicators
Markets Generally Hate Uncertainty
It was not surprising to see markets in South Korea and Japan sell off on the news of this change in North Korea. More than anything, markets hate uncertainty and there is now a gigantic red question mark where North Korean policy is now concerned. To that end, it is perhaps a bit surprising that gold was barely up as of early Monday morning.
In the short term, investors should expect South Korean equities like POSCO (NYSE:PKX), SK Telecom (NYSE:SKM), and KB Financial Group (NYSE:KB) to be soft. The South Korean military is on high alert and it is going to take a little time for South Korean investors to feel comfortable with even their own equities. (For more, read Introduction To Asian Financial Markets.)
Again, this comes back to uncertainty. Will the new leadership feel the need to "test" missiles near South Korean territory, provoke another dust-up at sea, or otherwise flex its muscles as a reminder that nothing has really changed in terms of North Korea's strength and its views towards it neighbor?
The Ramifications to the Neighbors
While outright war seems highly unlikely, investors in South Korea and China cannot rest completely easy. A war against an external foe is a time-tested way of papering over internal squabbles and tensions. Likewise, a true breakdown in the chain of command could lead to a grab for power that spills over.
Outright war would be a nightmare for South Korea. Companies like Samsung, Hynix, and Hyundai have become significant multinational corporations and such a massive disruption in South Korea would have ripples throughout markets like consumer electronics, technology, heavy industry and automobiles.
This uncertainty could also be a problem for China. China has been propping up and abetting North Korea for quite some time, garnering the benefits of not only putting South Korea, Japan and the U.S. on edge, but also cheap imports and resources from North Korea. It is an exaggeration to say that China depends on North Korea for irreplaceable inputs, but China is fighting its own battles with inflation, and needs all of the cheap inputs it can get. By the same token, North Korea is critically dependent upon China for its hard currency and food, so China has the opportunity to impose a certain degree of stability on the situation.
What Does This Mean for North American Investors?
In the short run, the death of Kim Jong Il means relative little for North American investors, other than those who hold stocks and funds heavily exposed to the South Korean market. Like as not, the market is going to assume that North Korean policy is going to remain more or less unchanged and that the consolidation of power will involve a few volleys of overheated propaganda and threats.
Should there be signs of actual internal instability or real military mobilization, the markets in North America will almost certainly drop significantly, not only because of the implicit damage to South Korea, but the expense of having to come to that ally's defense. Perhaps that would be a short-term boon for companies like Boeing (NYSE:BA) or General Dynamics (NYSE:GD), but the overall market performance would be generally poor.
Longer term, there seems to be more upside than risk from this transition. The worst-case scenario, actual military attacks on South Korea, is highly unlikely, as it seems that North Korea has long accepted that that would be a near-suicidal decision. The most likely scenario is that things go on as before; North Korea remains a gadfly and does its level best to convince the world it's crazy and unstable, so as to get bought off with much-needed aid.
There is another possibility, however vanishingly small it may be. This new North Korean leader was educated outside of North Korea and may appreciate just how isolated and backward the country has become. Is it impossible to think (or hope) that eventually North Korea could ease up and become a better global citizen? Countries like Vietnam have rehabilitated and taken a more capitalistic outlook, though countries like Cuba and Laos have been more stubborn and slow-to-change. Progress on this front would be a great development for South Korea, but it is unlikely to happen for at least five or ten years (if ever). (For more on the effects that political change can have on a formerly closed economy, read 5 Economic Effects Of Country Liberalization.)
The Bottom Line
Scary as it may sound, what happens to investors in South Korea and North America is largely in the hands of Kim Jong Un and the North Korean military. If order is maintained and if the new leader demonstrates more rationality than former heads of state, there will be little more than provocative language and a few maneuvers. The South Korean market will sell-off a bit, the country will be nervous, but things will get back to normal in a month or so.
If North Korea gets aggressive, then all bets are off for the South Korean markets and investors in Japan and the West will likewise worry and sell off shares (and buy gold). However, if North Korea decides to take a new path, perhaps the long-term outcome of this change will be a positive for investors and the world at large.
For Japan, it's all about that stability. Trade between Japan and North Korea is insignificant, but Japan does worry about the unpredictability of North Korea and the military threat it represents. Japan is not going to step up its military spending overnight because of this transition, but a more bellicose North Korea may well force Japan to reassess its needs; something it can arguably ill-afford, given its high debt and demographic problems.