Potential impact of the North Korean crisis by lindash


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									Economics@ANZ                      Potential impact of the North
                                   Korean crisis

                                   Implications for Asia and Australia

                                   Muted market reaction is spot on
13 October 2006
                                   North Korea’s announcement that it conducted a nuclear bomb test on 9 October
                                   has sparked a fury of diplomatic activity. The UN Security Council is deliberating
                                   on possible sanctions while the 6 countries involved in the 6-Party Negotiations
                                   with North Korea have been publicly and privately debating the next course of
                                   action.   North Korea itself has become more belligerent, stating that the
                                   imposition of full sanctions would be tantamount to an expression of war.
                                   The financial market reaction to heightened geo-political risk has been muted.
                                   Equity markets in Asia were down marginally, with Korea and Japan declining
                                   more significantly. The US dollar strengthened somewhat in a bout of risk
                                   aversion. But the sell-off was insignificant, and the recovery has been quick.
                                                                              Muted financial market response
                                     E x c h a n g e r a t e s , U S $ p e r l o c a l c u r r e n c y u n it ,                      S h a r e p r ic e in d ic e s
                                                                   in d e x e d
                                                                                                                190     1 Ja n 2 0 0 4 = 1 0 0
                                   115       03 Jan 2005 = 100

                                                                                                                                                                        K o re a
                                                                               K o re a
Authors:                           110                                                                          170

Amy Auster
Head of International Economics    105                                                                C hin a
+61 3 9273 5417                                                                                                 150

austera@anz.com                                                                T a iw a n                                         Ja p a n
Jasmine Robinson
                                                                                                                130                                                                HK
Senior Economist International
+61 3 9273 6289                     95
robinsj7@anz.com                                                                          A u s t ra l i a

                                    90                                                                                               T a iw a n

                                    85                                                                                                                        C hin a
                                                     Ja p a n

                                    80                                                                           70
                                     O c t -0 5    D e c -0 5    M a r- 0 6     Ju n -0 6          S e p -0 6     O c t -0 5    D e c -0 5        M a r-0 6        Ju n -0 6       Se p -0 6

                                   In our view, the market is correct in shaking off recent events in North Asia, as
                                   the fundamental economic implications are completely unclear. The threat of
                                   further nuclear tests reflects a defiant regime, but there are so many scenarios
                                   that could evolve from the present situation that it is impossible to price in the
                                   risks that emanate from North Korea’s actions. In this brief note, we review
                                   some scenarios and the economic implications for North Asia and Australia.

                                   Australia’s economic links with N Asia
                                   The situation in North Korea is important not only for the Korean peninsula, eg
                                   North and South Korea, but also for the North Asian giants of China and Japan.
                                   The Korean peninsula sits between these two regional powers, and the
                                   relationship between China, Korea and Japan has a troubled history. A political,
                                   social or military upheaval on the Korean peninsula has significant potential to
Our Vision:                        ripple through both China and Japan.

For Economics@ANZ to be the        Japan, China and Korea are, respectively, Australia’s first, second and third
most respected, sought-after and   largest export market for goods. Collectively, they absorb 40% of all of
commercially valued source of      Australia’s merchandise exports. They also are responsible for more than 90% of
economics research and             Australia’s iron ore exports, and over half of its coal exports.
information on Australia, New
Zealand, the Pacific and Asia.
 Economics@ANZ                                                                          North Korea - 13 October 2006

           Australia’s top 10 export markets                     3. Tight sanctions are imposed; North Korea
      2005           Goods        Services      Gds & Svcs          initiates limited military action (not including
                                                % share of          nuclear arsenal) against South Korea and/or
                     (A$ bn)      (A$ bn)                           Japan.

 Japan                28.41         3.13            17.9         4. Tight sanctions are imposed; North Korea
                                                                    initiates limited military action that includes
 China                16.12         2.49            10.6
                                                                    nuclear arsenal against South Korea and/or
 US                   9.26          4.43            7.8             Japan.
 Korea                10.95         1.23            6.9      Of the above scenarios, most observers tend to
                                                             believe that the future will lie somewhere between
 NZ                   9.00          2.75            6.7
                                                             #1 and #2 – eg, that rhetoric will be uncomfortable
 UK                   4.97          4.24            5.2      but military action will not occur. If so, there would
 India                6.98          1.03            8.01     not be any significant economic implications of the
                                                             North Korean crisis, other than bouts of US dollar
 Singapore            3.96          2.42            3.6      strength accompanying some of the more worrying
 Taiwan               5.52          0.42            3.4      headlines.

 Thailand             4.13          0.54            2.7      In a backward sort of way, this #1-#2 scenario
                                                             could be positive in the longer-term for North Asia,
 TOTAL               138.96         37.25           100
                                                             particularly if it assists with the new warming of
Source: ABS, Economics@ANZ                                   diplomatic relations between Japan and China. Over
                                                             the past few years, China has been on the opposite
As Economic@ANZ has written extensively, the                 side of the fence on the North Korean issue, holding
natural resources sector is one of Australia’s main          to its position that it is not opposed to any country
growth drivers in this business cycle, not only              developing     nuclear     technology   for  peaceful
because of the contribution to trade but also                purposes. China’s position on this issue, which has
because of the wealth effect of the investment boom          informed its relationship with both North Korea and
and rising share market. Make no mistake about it –          Iran, has been a thorn in the side of the US and
Australia’s economic future is heavily linked with the       Japan. Now that North Korea has clearly stated its
three largest economies of North Asia, and any               intention to develop nuclear technology for military
military conflict that significantly decreased demand        purposes, China’s position on North Korea has quite
for Australia’s key commodities exports would have           evidently shifted and could well continue to move
an immediate and negative effect on the Australian           closer in the direction of the US and Japan in the
economy.                                                     future.
            Australia's exports to North Asia                In addition to changes in China, the past month has
           2005          Japan       China        Korea      seen a major change in Japan with the election of
 Exports (A$ bn)         28.4        16.1          10.9      Prime Minister Shinzo Abe to succeed Junichiro
                                                             Koizumi in September. The hawkish Abe entered
 Iron ore (% sh.         11.7        35.6          10.1
                                                             office with a clear priority to restore closer
 of exports to          (30.0)*     (51.9)*      (10.0)*
 country)                                                    diplomatic relations with China, which became
 Coal                    31.8         3.3          23.2
                                                             strained during the Koizumi years through repeated
                                                             visits to the Yasukuni Shrine. The North Korean
                        (41.3)*      (2.4)*      (11.6)*
                                                             nuclear test occurred as Abe was in Beijing on a
*: Figures in brackets denote % share of total exports of
                                                             state visit, the first state visit from Japan to China in
Source: ABS                                                  five years. Thus, while Abe has raised some hackles
                                                             in Asia by calling for a constitutional amendment to
Potential for economic disruption                            remove restrictions on the mandate of Japan’s
                                                             military – some of which may be motivated by
While the stakes in this crisis are potentially huge, it
                                                             concerns about the future of Korea – an important
is important to remain clear-headed in identifying
                                                             détente with China has begun and may be
both the base-case and the worst-case scenarios,
                                                             strengthened by a sense of common purpose
and their probability of occurring. While claiming no
                                                             against a regional nuclear arms race.
expertise in political science or military strategy,
commentary from informed observers seems to hint             The #3-#4 scenarios around aggressive military
at the following possible scenarios:                         action by North Korea are clearly potentially more
                                                             negative for the North Asian region, but the
      1.    Some additional sanctions are imposed; no
                                                             economic impact would depend on the severity of
            further nuclear tests occur; rhetoric remains
                                                             the conflict and its length. Although military conflicts
            high but no change on the ground.
                                                             result in human tragedy and property loss, like
      2. Tight sanctions are imposed with the sign-          natural disasters they do not necessarily depress
         off of the Chinese and Russians; North              demand in the medium term because of the
         Korea undertakes another nuclear test;              required investment in military hardware and
         rhetoric remains high but no change on the          rebuilding in a post-war period. Steel, the main
         ground.                                             output that is created by Australia’s iron ore and

                                                                                                              Page 2
Economics@ANZ                                                                                   North Korea - 13 October 2006

coal exports to the region, would be heavily in                          North Korea : economic trends
demand in this scenario. The bottom line is that it is
impossible to project what the economic impact on                         GDP growth                        Structure of Economy
                                                                                                                       (% of GDP, 2004)
Australia would be of a military conflict on the            7    % YOY
Korean peninsula. A short term disruption to                                                                          Electricity, gas & water
                                                            5                                                                             Agriculture, forestry
Australia’s exports to the region would be expected,        4
                                                                                                Services (32.3%)                           & fisheries (26.7%)

but the medium term and longer term implications            3
cannot be assumed.                                          2

North Korea’s longer term future                            0
In all of the concern about North Korea, it is             -2

important not to overlook the fact that this is a very     -3
poor country with an extremely authoritarian and                                                Construction (9.3%)
                                                           -5                                                                  Manufacturing
isolated government. Nobody knows the rationale            -6

behind the timing of Kim Jong-Il’s motivation to test      -7
nuclear weapons, but the possibility that the test              95 96 97 98 99 00 01 02 03 04

was undertaken to distract the North Koreans from         Sources: Bank of Korea

the desperate state of the country or to bolster
support for the regime cannot be discounted.
                                                          Economic impact muted, for now
    North and South Korea – A Comparison                  Our base case scenario is the #1-#2 scenario
                                                          outlined above, in which diplomatic wrangling
             2004                North        South
                                                          continues but military confrontation is avoided. We
 Population (mn)                  22.7        48.1        therefore do not anticipate a significant economic
 Nominal GNI (US$ bn)             20.8         681        impact in the coming months, although there may
                                                          be financial market reaction to headlines related to
 GNI per capita (US$)              914       14,162
                                                          this issue. Nonetheless, the situation remains
 Real GDP growth                   2.2         4.6
                                                          unpredictable, with great potential to affect
 Energy Industry                                          Australia’s economic outlook in the longer term
 Coal (1000 tons)                22,800       3,190       should the worst case scenarios come to pass.
 Actual Power generation          20.6        342.1
 capacity (bn kW)

 Crude oil imports (mn bbl)        3.9        825.8
 Agriculture production
 Grain (1000 tons)                4,312       5,669
 Rice (1000 tons)                 1,800       5,000
 Mineral production
 Iron ore (1000 tons)             4,579        226
Source: Bank of Korea

It well known that the economy is very weak and
that millions of North Koreans are starving. The
imposition of further sanctions, if successful, could
potentially bring about the eventual collapse of the
regime. This is possibly the most significant political
and economic scenario out of all of the above. A
collapse of North Korea and potential reunification
with South Korea would shift the balance of power in
North Asia and represent both a major economic
and political event. Like the reunification of
Germany, an equivalent situation in Korea would
initially involve a massive humanitarian relief effort
followed by a substantial and prolonged need for
investment in an effort to improve the living
standards of North Korea.

                                                                                                                                                 Page 3
 Economics@ANZ                                                                                        North Korea - 13 October 2006

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