North Korea's escalation strategy continued last week with the testing of a thermonuclear bomb, but market reform may be the regime's most potent weapon, writes Mirae Asset Daewoo's Peter Kim.
The latest test is North Korea's sixth nuclear testing, and possibly the first hydrogen bomb, which is much more powerful than an atomic bomb.
Hydrogen bombs are also much more efficient, and Kim has declared it ideal for mounting on an intercontinental ballistic missile (ICBM).
Regardless of the validity of the claim, it is hard to doubt that North Korea is advancing its nuclear and ICBM technology faster than any western experts expected.
The timing of the testing is meaningful, given that Kim waited until the joint US-South Korea military exercises concluded before the testing the bomb.
Traditionally, North Korea makes a point of making an aggressive protest to the annual event. Kim did, however, fire a missile that passed above Hokkaido, Japan last week to remind us that he is still a force to be respected.
President Trump's "fire and fury" threat if the US is targeted, which made no mention of its allies, seems to influence Kim's strategy at least in the short-term.
President Trump continues to display an aggressive front by declaring that “all options” are possible to the US in countering the nuclear threat.
But it would be a mistake to think that President Trump is winning the war of two bullies as we maintain that options are fast running out for the US.
On current pace, North Korea is expected to develop its ICBM technology to reach the west coast of the US within the four-year term of President Trump.
It is inconceivable that a US president would accept a legacy of allowing a nuclear threat to develop during his watch. We believe Kim Jong-un will gradually escalate tensions with its ICBM and nuclear over the next two years.
We believe Kim Jong-un will not engage in a 'flash point' event until it has fully developed its ICBM to reach the US west coast when its bargaining position would be at its optimal.
As for China’s stance, our premise is that Kim is acutely aware that its ally China has undermined North Korea’s political leverage as its caretaker.
For the past few decades, China has gratefully accepted its role as the safety net for the world ensuring that North Korea remains under control.
North Korea, on the other hand, has seen limited benefits under China’s shadow. North Korea's nuclear capabilities will enable it to gain leverage over the world, but first, it has to show that it is no longer under the control of China.
Since President Trump declared the possibility of a pre-emptive strike, China has shown little to display its influence on Kim.
As North Korea stalls for time, the US and the United Nations intensify its economic sanctions in the hopes of a change in attitude from Kim Jong-un.
In the history of North Korea, economic sanctions have yielded little results from a regime that shows little regard for the well-being of its people.
Having seen millions of its citizens die from starvation during the famine of 1994-1998, to expect economic sanctions will deter Kim Jong-un’s grand plan only indicates the limited options left for the US.
Another miscalculation from the US comes in the underappreciated strength of the North Korean economy. Kim Jong-un is establishing strong support via economic reform based on promoting the middle class.
There is evidence that the North Korean economy is growing despite US-directed economic sanctions and a reduction in aid from China. Since he took over in 2011, the flow of defectors from North to South Korea has surprisingly declined.
UN sanctions devised by the US still see North Korea as an impoverished nation barely feeding itself, which could be a major miscalculation as Kim gratefully deploys his stalling tactics while developing ever more dangerous tools for his global extortion.
It would seem that North Korea is making stealth progress on market reform. If the data and analysis are anywhere close to being correct, the latest UN sanctions that claim to take away $1 billion of North Korea’s exports will not have the desired impact.
Ultimately, Kim is seeking rewards multiple times those figures far into the future. After decades of planning and sacrifice, it would be a critical mistake to assume that short-term sanctions will change Kim’s plans.
China buys an estimated $100 million worth of coal annually from North Korea. But economic sanctions or severing of trade relations will not deter North Korea’s efforts to monetise decades of sacrifice and investment.
The economic surprise comes from a rare constructive policy action by Kim where he endorsed his people to engage in basic trade and commerce when he came into power.
Since then, there are growing stories of an emerging consumer class benefiting from the trading of goods made from raw materials coming from China.
North Korea may be making strides in productivity and income similar to China from in the 1990s. It is ironic that in an era where most economies are shifting to socialist values, North Korea is one economy that is embracing capitalism, from a rock-bottom base, of course.
Last week, US and Japan proposed for the first time oil sanctions on North Korea. For North Korea, oil is the most important commodity as it is critical to its armed forces and winter heating.
For decades, China has reluctantly agreed on UN sanctions on its ally North Korea but has continued to be the sole supplier of energy to North Korea, knowing that cutting off oil to North Korea could fatally sever its already tenuous relations.
Therefore, China’s response to the US and Japan’s request for oil sanctions will be a critical turning point for escalation of North Korea risk for financial markets.
With Trump, the perception of risk is rising as it requires two aggressive parties to form a war. The indifference of financial markets to the sabre-rattling is disturbing as it will make Kim even more determined to escalate his incursions to unprecedented levels.
Over the past few years, Kim has set a couple of dangerous precedents of bombing a small South Korean village and sinking a South Korean navy vessel without any repercussions.
Going forward, Kim could be tempted to raise stakes beyond those types of events to test how the US responds. As risk perception escalates, so will be the price of North Korea’s demands.
Peter Kim is an investment analyst at Mirae Asset Daewoo.
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