When asked by the press and clients what investors should do as a result of North Korea’s escalating threat, I have answered “Do Nothing”. Now, this is not a result of disinterest in the topic. My father was an ambassador to the United Nations in the 1990s, with his area of expertise being nuclear non-proliferation, so while for most people Sunday evening dinner conversations touched on the Giants or the Yankees, for us the time would be spent getting into the weeds on the situations in Iran, Iraq or North Korea. (This also partly explains my lack of friends in middle school.) Additionally, in my last role at JP Morgan, I got to learn about geopolitics within an investment framework from my mentor George Iwanicki, who is a prolific global historian (second only to my dad). In other words, I know enough to know that this topic is complicated and thus it is very difficult to predict a particular outcome… and even more difficult to predict how the markets will react.
Nevertheless, despite the North Korean developments being difficult to predict, it is important as a global citizen to understand what is going on. So here goes my shot at providing some context.
Ok, so why is all of this happening? Why are we talking about a desperately poor country of 25 million people on the other side of the world? The best way to understand anything is to understand its origin, the players, and their incentives. So, first I will explain how North Korea became North Korea, which should help to provide the necessary color for the next part: who are the main players and what are their incentives. In a few day’s time, I will touch on the last part: the likely scenarios going forward based on the main players’ incentives.
How did North Korea come to be?
Many of us know that North Korea is a rogue state of ~25 million poor people, led by a dictator who is trying to build a nuclear bomb; but what led this country down this path. What got them here?
Post World War II —> Cold War —> Korea splits
As soon as World War II ended, the world separated into two blocs – one led by the United States and the other, the Soviet Union. This period became known as the Cold War in which the two separate political and economic systems (capitalism and communism) fought proxy wars all around the world, like the Chinese Civil War, the Korean War, the Cuban Revolution, and, later on, the Vietnam War. The reason the two countries engaged in proxy wars instead of head-to-head battles is that since 1949 both countries held nuclear weapons, which, if used against each other, would lead to mutually assured destruction.
In 1949, the Soviets had a big win with China’s Civil War resulting in a communist revolution that turned the Chinese towards the communist bloc. Just a few years earlier, Japan began pulling back from territories it had occupied in WWII, which included the Korean peninsula. Yea, that’s right, Japan occupied North and South Korea from 1910 until 1945. As Japanese forces pulled out of Korea, Soviet forces took over North Korea while the U.S took over South Korea. By 1948, both sides had separate governments claiming to be the legitimate government of Korea as a whole. By the summer of 1950, the Soviets consolidated power in North Korea under Kim Il-sung, who led North Korean forces, backed also now by communist China, to invade the south. The U.S, backed by the United Nations allies, pushed the communists back to the north and, after three years of war, a stalemate was reached at the 38th Parallel, smack in the middle of the Korean Peninsula. Both sides signed armistice establishing a demilitarized zone. However, interestingly enough, no peace treaty was ever signed so they are technically still at war.
By 1970, Kim II-sung’s party completed a bloody political transformation from traditional communist political party rule to dictatorship. By the 1980s, he transitioned power to his son Kim Jong-Il, solidifying the dictatorship into a family affair.
Collapse of Soviet Union, cold shoulder by China —> North Korea radicalizes
In the following decades, South Korea’s economy flourished as they adopted the Japanese and American models of industrialization, whilst North Korea’s dictatorship dependency on Russia and China, left them in the dust, economically speaking.
The heavy U.S. financial support and capitalist approach slowly transformed South Korea into one of the most educated and technologically advanced countries in the world. Fast forward to the 1991 collapse of the Soviet Union and the communist bloc around the world – North Korea could no longer depend on the Soviet’s economic support or nuclear umbrella protection. As we can see in the chart below, which shows GDP per person (a proxy for countries living standards) not being a capitalist country participating in globalization in the last 50 years has really sucked.
To add further insecurity to North Korea, in 1991, the U.S.’s decisive victory against Iraq’s Soviet-equipped army, made North Korea’s Soviet-based arsenal seem obsolete. Finally, the Chinese began to embrace political relations with the U.S in the 1970s and commercial relations with South Korea in the mid-1980s, and by 1992 South Korea had re-established diplomatic relations with a China that had become warm towards capitalism.
All these blows alongside a faltering domestic economy left North Korea’s leadership isolated and vulnerable. So if you are North Korea’s leader, how do you stay relevant in the region and retain power in this situation? You build a huge army and nuclear weapon capabilities.
North Korea started developing nuclear technology in the 1990s under the pretenses of creating energy for peaceful ends and it was actually lawfully doing so under international supervision until 2002. During the Bush administration (2001-2009) relations with North Korea deteriorated, leading to North Korea defining the U.S. as a hostile country and Bush labeling North Korea as part of the “axis of evil”. The rift culminated in North Korea exiting the nuclear Non Proliferation Treaty (NPT) in 2003.
After North Korea exited the NPT, there were many rounds of negotiations between 2003 and 2009 under the framework of the “Six Party Talks.” During these talks, South Korea, Russia, China, U.S. & Japan participated in an attempt to dissuade North Korea from developing nuclear weapons – but to no avail. As you can see in the below chart from the Washington Post, North Korea continued to improve their nuclear and delivery mechanisms, despite the ongoing talks.
In 2011, Kim Jong Un becomes North Korea’s leader after his father passes away and he ramps up nuclear efforts by 2013.
Present Day: Conflict Escalation
Skip forward to the last eight months, where we saw a bunch of tit-for-tat words between President Trump and North Korea. A few weeks back, we learned that North Korea has an intercontinental ballistic missile that is theoretically capable of hitting major U.S. cities. Then just last week, the North Koreans claimed to have successfully tested a hydrogen bomb which, as per the above graphic, is 10 times stronger than their prior nuclear tests. If found to be true, North Korea has joined the nuclear club (which surprisingly only includes 7 other countries) and therefore significantly alters the playing field in the region.
Who are the main players & their main incentives?
The picture above depicts the players and where they stand when it comes to supporting the two opposing sides of this developing conflict i.e. U.S. and North Korea. Let’s go through each player and their goals regarding this conflict.
North Korea: Stay in power, gain leverage
North Korean leadership wants what all dictatorships want: to stay in power. They want a nuclear bomb, not to use it, as that would surely bring an end to their regime, but to deter anyone from attempting to replace them. Their rationale most likely being that previous dictators, who were pressured into giving up nuclear ambitions, like Iraq’s Saddam Hussein or Libya’s Muammar Qaddafi, were eventually brought down. Another potential goal could be that by becoming a nuclear power, North Korea can find it itself in a better position to re-engage politically and economically with the West without having to answer to China. (More on this theory on our part II of this blog.)
As mentioned earlier, China was one of the countries that occupied North Korea when the Japanese retreated post-WWII. Amongst all parties in the region, China has the closest ties to North Korea, both economically and politically (both communist). China essentially uses North Korea as a buffer against “U.S. influence”. Think about it, China’s neighbors to the East are Japan and South Korea, who together have over 62,000 American soldiers stationed there. Not too far to the south, China has the Philippines, which has long been a U.S. ally and houses over 5 military bases that U.S military personnel have access to.
Want further proof that China wants the current North Korea regime to stay in place? Look at the chart below – it shows North Korea’s imports by destination. 85% of North Korean imports come from China and 83% of North Korea’s total exports go to China. If China wanted North Korea’s leadership toppled, they would just cut supplies of food and oil leaving the country, and stop importing coal and iron ore from North Korea. But China doesn’t want to do that. They would like to use the leverage of calling on North Korea to suspend its nuclear weapons program, in return for the U.S. tending its military exercises in the region. In other words, “U.S., get off our turf and we will stop North Korea from turning nuclear”.
North Korea Imports By Origin Country (2015) Source: OEC
South Korea: A weak, non-aggressive North Korean regime
From a military standpoint, South Korea clearly stands with the U.S. in avoiding North Korea’s nuclear capabilities. The country depends on the U.S. troops stationed there, as well as the U.S. nuclear capabilities, to defend themselves.
So, South Korea does not want an aggressive North Korea, but they also don’t want a massive migration of 25 million poor and hungry North Koreans across their borders, which would happen if the North Korean regime suddenly tumbled. So for South Korea, containment and diplomacy are in their best political interest.
Additionally, it is important to keep in mind that exports account for 42% of South Korea’s economy (v.s. 12% for the U.S for instance) with its biggest trading partner being China. Get this, for South Korea, 25% of total exports go to China and 21% of imports come from China. Yes, the U.S. is still an important destination for them (14% of their total exports) but China remains their largest trading partner, by far. So although militarily speaking, South Korea clearly stands with the U.S., economically speaking it doesn’t really want to piss off its biggest trading partner, China.
Russia: Leverage against the U.S.
As mentioned earlier, North Korea has deep-rooted ties with Russia since the Soviet Union occupied the country post-WWII and supported it both economically and militarily until the collapse of the Soviet Union in 1991. Post-1991 Russia’s global power has diminished, but their relations with North Korea has remained warm. Russia’s ultimate goal is to exert more global influence despite its diminished military presence and a way to do that is to act as a broker between North Korea and the West.
Ultimately, Russia wants a North Korea without nuclear capabilities but with the intent of becoming nuclear one day (I told you this was complicated!).
As mentioned earlier, Japan colonized North Korea just a few decades ago, so the two countries are not really BFFs. Since WWII, Japan has relied on the U.S. military presence for protection and they are therefore the closest U.S. allies when it comes to dealing with North Korea, as they can’t really defend themselves alone. Similarly to South Korea, Japan doesn’t want military conflict in their backyard, especially considering that they are within North Korea’s missile range.
United States: Get North Korean leadership out, or weaken them
Ideally, the U.S. would love a reunited Korea under a U.S. friendly regime, but they’ll settle for a divided Korea with a North Korean leadership that doesn’t have nuclear capabilities and is not antagonistic towards the West. The fear of a nuclear North Korea is not only that they would use the weapons against the West, but also that they would sell them to non-state terrorist groups like ISIS. Remember, with thousands of U.S. troops in the region and the role of peacekeeper, the U.S. is now at risk of losing the allies’ confidence in their ability to do its job. Imagine trying to explain to your people why a foreign country has a huge military presence in your land, but it can’t even defend you against a nation that economically speaking is smaller than a mid-size U.S. business. Ultimately, the U.S.’s main goal in that region is to keep China’s global ambitions at bay. The more defiant North Korea is towards the West, the greater China’s “soft power” is in the region. And the greater China’s power in region, the less power the U.S. has.
Ok, probably more than you needed to know. In the next post, I will discuss likely scenarios going forward.
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**The projections or other information generated by Zoe Financial, Inc. regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.