The cost to Australia

All the elements for a major international crisis are building in North Asia. And that looms as a major issue for Australian investors. North Asia takes 45% of Australia’s exports and provides 30% of our imports. Much of the recent boom in commodity markets has been built on the back of demand from North Asia, particularly China.

This has provided a significant underpinning to the Australian sharemarket over the past three years. What's more, it’s not just mining companies that are suddenly exposed to a heightened level of political risk. Other corporates such as Macquarie Bank and Coca-Cola Amatil have direct operational exposure on the Korean Peninsula. So far none of this risk has been factored into share prices. Over the coming weeks that might change.

North Korea is no ordinary country. It is unique in many ways, perhaps in history. Other so-called “rogue states” might do a bit of terrorism here and there, or clandestinely sell weapon systems to other pariahs, but no other country I’ve heard of actively counterfeits foreign currency or engages in drug running. North Korea is led by their “Dear Leader” Kim Jong-il. Here’s how he describes himself:

"Because of the immortal feats he has performed for mankind, his extraordinary intelligence, outstanding leadership ability and lofty communist virtue, the great leader is supported and boundlessly revered by the people."

Under his father’s tutelage in the 1980s, the “Dear Leader” was head of state security. Reportedly he masterminded the bombing of the South Korean cabinet in Burma (17 dead) in 1983. And in 1987 he authorised the bombing of a South Korean airline over the Pacific (115 dead). After he took control of North Korea on his father’s death, perhaps two million North Koreans starved to death in the 1990s due to his failed agricultural policies. Another 400,000 or so have died because their political thoughts were not in tune. When not sowing death and destruction, he likes to dabble in the film industry. He likes it so much, he arranged the kidnapping in Hong Kong of two South Korean film directors. Is he mad, is he bad? Probably both. And now he has nukes; or so he claims.

US response

The question is, what will the US do? Recent comments by its diplomats suggest their response might be more robust that markets currently expect. Consider the following US diplomatic comments made last week.

“(North Korea) can have a future, or it can have these (nuclear) weapons. It cannot have both.”

"We are not going to live with a nuclear North Korea; we are not going to accept it,"
'” Assistant US Secretary of State Christopher Hill.

“They should not test this nuclear device and if they do test it, it will be a very different world the day after the test."
'” US Ambassador to the United Nations, John Bolton.

I believe such language from diplomats suggests something more than just sanctions. To me these are “fighting words”. The first port of call for the US is the United Nations. The US has already said it wants additional sanctions on North Korea. But it also wants the right to inspect all cargo entering and leaving North Korea. And the US wants a Chapter 7 resolution, which would provide military backing for such inspections. Such talk smacks of a blockade; perhaps where only vital supplies, such as essential foodstuffs, are allowed into North Korea. Such action would be only partly effective unless China and Russia fully co-operated. They might offer some co-operation, but perhaps not full co-operation.

The possible escalation

On Tuesday a North Korean official was quoted as saying: "We want this situation to be concluded before the unhappy situation arises in which we fire nuclear missiles, and this depends on how the United States acts."

There are reports that the North Koreans are preparing a second nuclear test. If they are squeezed enough, in my opinion it is very likely that the North Koreans may escalate this “cold war” into something far “hotter”. Or, just as bad, the Americans might think the North Koreans are preparing for a “hot” war. At that tipping point, sanctions and blockades could morph into a military strike against North Korea. As I see it there are a couple of escalatory scenarios:

1. US retaliatory bombing of some or all known North Korean nuclear and missile facilities. Now we’re getting serious. From the American perspective this has the benefit of removing the immediate nuclear threat and very importantly sends a warning to that other nuclear pariah Iran. However, it also risks a highly probable North Korean military response. This could be quite vigorous. Last weekend, even before the “bomb” had been tested, some North Korean soldiers crossed the Military Demarcation Line in the demilitarised zone (DMZ) between North and South Korea. This was the first such incident since May. For the North Koreans, probing along the DMZ has a dual purpose: first it flushes out South Korean weapons systems (it would be handy to know where these are in the event a full scale attack is required); second, it lets the Americans know that the North Koreans will respond vigorously to any provocations.

2. The Americans might decide “if we’re going to bomb the North Korean nuclear and missile facilities, the North Koreans will launch a military response. Might as well take out the North Korean command and control facilities as well.”

Around this point South Korea would have a real problem. It is thought the North Koreans have aimed something like 10,000 artillery pieces at Seoul, the capital of South Korea. Seoul would very quickly become a “killing ground”.

There is also a significant chance any conflict would spread to at least US bases in Japan, if not Japan itself. Reportedly North Korea has targeted Japan with its missiles. So Japan becomes involved.

The response of China to an American air attack on North Korea is also problematic. Right now China is pretty annoyed with North Korea. So just as at the outbreak of the Korean War in 1950, China would probably not respond militarily to an American air attack at the first instance. But one thing could lead to another, and before you know it, a ground war on the peninsula could lead to some sort of Chinese military intervention, just like 1950.

In the midst of this chaos the China/Taiwan issue might resurface. The Chinese might decide that the Americans are distracted elsewhere. The Chinese might trade co-operation in Korea for a free hand in Taiwan. Perhaps Taiwan decides nukes aren’t a bad defence option after all. The permutations that could lead to a widening of any conflict to include Taiwan are endless.

At this point the world has a real problem. But you wouldn’t know any of this from viewing the financial media. I have seen no discussion at all in the markets over the past week on the consequences of a North Korean nuclear test. I am concerned at how complacent markets are towards this risk. Markets are always vulnerable to “Factor X”, that event from left field that no one foresaw. An escalation of the North Korean nuclear crisis, in my opinion, fits the bill perfectly.

Markets are probably reasoning that there have been so many storms on the peninsula before that this is just the latest and will probably blow over. Perhaps the markets are right.

Perhaps the markets don’t see the significance of the North Korean’s testing a nuclear device. After all, there are plenty of other nuclear devices in the world. The Americans, for example, own thousands.

The Americans have so far not announced any additional weapons deployments. But US military deployments are probably happening or at least being planned. In my view they just haven’t been announced yet. An immediate attack by the Americans on North Korea is unlikely but a situation spiralling out of control is a distinct possibility.

Economic consequences

I think there would be many probable market impacts from a military escalation on the Korean Peninsula, and they are mostly bad. The first is at the stock-specific level. Any stock with Korean interests would become poison. Two that come to mind are Coca-Cola Amatil (with only 2% of EBIT derived from Korea) and Macquarie Bank. Macquarie has expanded its Korean interests aggressively in 2006 with the Macquarie Korea Opportunities fund. This is an unlisted infrastructure fund with a targeted size of $2.7 billion.

After the fighting finishes there may be lots of opportunities. In addition, Macquarie has interests in 17 other infrastructure assets mostly through its Macquarie Korea Infrastructure Fund. These assets range from toll ways to energy utilities.

More broadly, any stock with North Asian exposure would also feel a chilly breeze running through its stock price. This would include most of the resource stocks. Over the past three years the Australian resources sector has experienced a super cycle built largely on the back of the China growth theme. For example, 20% of BHP Billiton’s sales now come from China, up from less than 10% two years ago. Most other resource companies would have a similar dependency.

But this is only the direct link. Many commodities have seen their prices rise by as much triple over the past 12 months, with higher Chinese demand responsible for a good portion of that rise. If fighting broke out on the Korean Peninsula you could almost certainly forget about that theme, and the resource stocks leveraged to it.

There might be some winners. A flight to safety should be expected, so the US and Swiss currencies are also likely to benefit. Other winners might include gold and gold stocks '¦ maybe oil and oil stocks.

Putting aside individual company impacts, Australia arguably would be one of the most affected Western countries if hostilities break out in North Asia. The Department of Foreign Affairs and Trade says North Asia absorbed 45% of our exports and provided 30% of our imports in 2005. China and Korea alone took 20% of our exports and provided 18% of our imports. The balance of Australia’s trade with North Asia was with Japan and Taiwan.

At the very least, the Australian dollar would likely experience significant downward pressure. No Australian company or individual would be immune from fighting on the Korean Peninsula. At the macro level the economic impact on Australia could be severe.

And now for the bad news

In general wars are bad for markets, unless you’re winning. When a war breaks out unexpectedly, the immediate market impact can be severe. There is a recent precedent. When fighting unexpectedly erupted between Israel and Hezbollah in mid-July, the US and Australian sharemarkets promptly fell 4–5%. But that was a small war, in a land, far, far away. And one of the combatants wasn’t even a country. In my view the impact on sharemarkets around the world, but particularly in Australia, from an outbreak of hostilities on the Korean Peninsula, could be multiples of what we saw in July. And none of this risk is being discussed in financial markets let alone being factored into prices, yet. Factor X.

For most of us it is beyond belief that another Korean War could break out. After all, the first one ended 53 years ago and for most of us, it’s consigned to the history books. The problem is the first one only ended with a truce. There was no peace treaty signed. History is littered with inconclusive wars fought between the same countries which sometimes span centuries: The Romans fought the Punic wars; the British fought the French over a 500-year period; everyone fought the Germans twice last century. Then there is the many Arab/Israeli wars and even in the past 15 years the two Iraq wars. So judging by history, another round of fighting on the Korean Peninsula is not beyond imagination.

For 13 years to 2005 Mike Mangan was a highly rated media analyst, most recently with Deutsche Bank. In the 1980s he was an Australian military intelligence officer specialising in combat intelligence. He served as a platoon commander in Delta Company 6RAR and as the Intelligence Officer for the 2nd Cavalry Regiment.