Never Mind the North Koreans

There has been a lot of hype surrounding the little peninsula of Korea lately. As you’re no doubt aware, an international commission recently determined that a North Korean torpedo destroyed a South Korean Cheonan battleship.

Markets are a bit spooked and the press is eating up daily comments from Asian leaders and US representatives – as well as denials by North Korea and calls for calm from China’s officials. President Myung Bak Lee has denounced the North’s actions with hostility, demanding an immediate and sincere apology. But UN officials aren’t holding their breath. The confrontation has a lot of investors and traders second-guessing whether or not war is imminent, hurting an economy that is on the rise.

But contrary to popular belief, there isn’t much to be concerned about.

First and foremost, the recent events are not the worst that we have seen between the two nations in the last five decades. That’s not to downplay the tragedy, but it is just the continuation of a civil feud between these two nations. Remember, the Korean War itself isn’t fully resolved – North Korea simply signed an armistice in July 1953, but there was no formal surrender. And it seems like every few years North Korea finds a way to rattle its neighbors. About four years ago North Korea got their hands on long-range missiles. Test firing them over the Sea of Japan, the North Korean government received warnings from leaders of both Japan and South Korea as well as glares from the United States and other nations. Ultimately, the incident was resolved and things went back to the way they were. A whole lot of nothing.

And even under these unpredictable threats, the South Korean economy continues to grow at a constant average rate. For the last five years, aside from the US credit debacle in the tail-end of 2008 to 2009, the country has shown a positive 4.5% rate of economic advancement. Partly due to manufacturing and exports, the country has been developing its financial sector offerings while broadening its technical creativity and innovation. It’s a known fact that South Korea’s infrastructure is so advanced that techno-fiends have flocked to see the world’s most wired country. The nation is also benefiting immensely from Asia’s recent period of growth on the back of China’s climb to power. As China has revved up its economic engine and cranked out cheap goods, smaller countries like Japan and Korea have been benefiting from afar. Ranked as China’s fourth largest trade partner, behind the United States, European Union and Japan, South Korea is definitely moving its way up Asia’s ranks. These facts make prospects for continued growth look brighter for the coming years.

It is interesting to note here that higher rates of growth are likely to spark inflation at the consumer level. The dynamic has been seen in every economy during its heyday of the last decade and throughout economic history – rising growth increases consumer prices.

What to do? South Korea’s central bank is likely to do what any central banker would: increase interest rates in order to combat lower prices. If it’s one thing investors like, it’s higher rates of return on interest. It will be this interest that supports demand for the currency as foreign direct investment clamors for more and more South Korean won.

It is this particular demand that is going to benefit the Korean currency in both the long and short term – with Chinese yuan speculation adding to the momentum. As mentioned above, the two countries share strong economic and trade ties that date back to the beginning of time – having strengthened both countries. And why not their currencies as well? Currently, the Chinese currency is fixed to fluctuate with the US dollar. However, its movements are being contained by a government-controlled band. This helps to create a rather stable currency, and one that US politicians aren’t too fond of. A controlled currency means that the government is fixing the rate of exchange. In this case, it means a lower exchange rate for the yuan, which helps exporters undercut their competition with lower prices. The strategy has sparked a round of complaining by global leaders of uncompetitive practices that the Chinese have done over the years. Rising discontent has many in the market betting that policymakers in Beijing will cave to global pressure, implementing a one off revaluation – effectively allowing the currency to appreciate. Should this event actually materialize, people will be betting their bottom dollar that the Korean won will appreciate handsomely.

So, yes, North Korea can expel South Korean workers from the shared Gaesong factory complex and vow tactical retaliation for the loudspeakers at the border playing South Korean propaganda. Additionally, the United States can condemn the actions of the North, calling for unequivocal support for the South and UN sanctions against North Korea.

We have been here before, and will likely be here again as long as the Peninsula remains divided.

In other words, speculators shouldn’t be hesitant. South Korea still offers great underlying fundamentals. When things die down, markets will revert back to demanding currencies with riskier profiles and realize that the news of North Korea didn’t matter.

Richard Lee
for The Daily Reckoning