Pyongyang's Test: What's the Impact?

After North Korea's nuclear power play, S&P says prospects of severe economic sanctions or full-scale military conflict on the peninsula are remote

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From Standard & Poor's RatingsDirect
The Central News Agency of the Democratic People's Republic of Korea (North Korea) announced Oct. 9 that North Korea successfully conducted a nuclear test. Although the test was not confirmed by seismic observation or other measures, in the view of Standard & Poor's Ratings Services, a successful nuclear test would not by itself result in a downward revision of the sovereign ratings on the Republic of Korea (S&P sovereign credit rating, A), or negatively affect the stable outlook attached to the country's ratings.

This is because the prospect of a nuclear test leading to economic sanctions severe enough to hasten a collapse of the North Korean regime, or worse, spark a full-scale military conflict, are still remote.

Standard & Poor's base scenario is that the process toward nuclear disarmament of North Korea will be protracted, and results will be slow and uncertain. The solution, however, will ultimately be a peaceful one. The regime's survival is still the prime motivator for North Korea's leaders.

NECESSARY TRADE. Consequently, while the leadership's actions will continue to be provocative, they're aimed at deterring what it perceives as an invasion threat, and also at extracting more concessions from the U.S. and South Korea. The goal is not to expose the regime to the risk of military reprisals. It's ultimately not in North Korea's interests to raise the level of brinkmanship too far, too quickly, because the more it escalates existing tensions the fewer bargaining cards it holds.

Regime survival in North Korea is predicated on a flow of trade in goods and foreign exchange into the country—estimated to be around $2 billion to $3 billion—to keep the military elite and senior regime cadres in line and to keep North Korea's crumbling economy from imploding. This estimate comprises legitimate imports and exports, including payments-in-kind and donations, as well as foreign exchange receipts from alleged illicit activities, such as weapon sales, counterfeiting, and drug running.

The U.S. has already taken steps to interrupt this flow through financial institutions it suspects of taking part in these illicit trades—moves that have infuriated North Korea. Steps include sanctions against a Macau bank, Banco Delta Asia, and requests to Russia, Vietnam, and other Asian countries to investigate North Korean bank accounts.

HARSHER PENALTIES? Japan, which imposed sanctions following the July 4 missile tests—including stopping ferry services to the North—is considering further economic measures such as restrictions on remittances and banking transactions.

The nuclear test would provoke even harsher penalties, such as quarantining North Korean vessels, along with travel bans, a broad trade ban, and restrictions on investment and remittances. Such sanctions would tighten the financial squeeze on North Korea's leadership, and increase the risk of a collapse in the regime.

Although still an unlikely prospect in the near term, if the regime were to fall, this would increase the probability of South Korea realizing its contingent liabilities for the costs of reunification. For South Korea, therefore, the severity of the sanctions that would be imposed following a nuclear test is a critical issue.

CHINA'S REACTION. China, although it would oppose harsh sanctions, is apparently losing some of its enthusiasm for Kim Jong Il, particularly after the North ignored China's request not to conduct missile tests in July, 2006. How long China is prepared to tolerate North Korea's antics in the interests of preserving the status quo is an important question. China has a lot to lose if North Korea's nuclear test proves successful, particularly as it could result in Japan adopting nuclear weapons in order to counter the threat from North Korea.

However, China has more to lose from a regime collapse, which could spark a large influx of refugees into China and result in a reunified Korean peninsula, with U.S. troops on its border.

Nevertheless, even as tensions ebb and flow on the Korean Peninsula, Standard & Poor's has maintained its stable outlook on the sovereign rating on Korea, highlighting our assumption of a peaceful resolution. It remains Standard & Poor's view that neither of the Koreas wants to propagate war and that both the U.S. and China will continue to dedicate their resources to preventing such a conflict.

NO CHECKS AND BALANCES. The U.S. maintains a significant conventional force in Korea, and it is committed to guaranteeing the security of the South. While the recent plan to transfer wartime operational control of forces from the U.S. to Korea is a significant issue in terms of regional security, it does not necessarily indicate any lessening of support. It will, however, add to the Korean government's increasing costs to maintain its military.

Despite expectations that the conflict will be resolved peacefully, the conflict with the North is still the largest credit risk for Korea. North Korea's authoritarian regime, which has a highly centralized decision-making process, is still an unpredictable neighbor. The decision to go to war rests largely in the hands of Kim Jong Il, as the checks and balances that can be found in democracies such as South Korea and Taiwan do not exist in North Korea.

The highly independent nature of the regime also undermines the leverage the U.S. and China might hope to wield. At the same time, if the tension between the U.S. and North Korea increases and a standoff is prolonged, it could adversely affect Korea's economic prospects.

The testing of a nuclear weapon by North Korea in particular would hurt consumer confidence, could depress investment flows, and is likely to prompt even higher defense spending. This would affect growth prospects for South Korea and could have a negative impact on its sovereign credit ratings over time.

Ogawa is a credit analyst for Standard & Poor's Ratings Services

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
Standard & Poor's Regulatory Disclosure

Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.

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