By Lee Myong-hwal
Senior research fellow, Korea Institute of Finance

The death of North Korean leader Kim Jong-Il last December carried geopolitical risks for the Korean Peninsula. In the past events in the North gave rise to immediate financial market volatility although it quickly recovered not long thereafter to return to its previous levels.

The long-term impact therefore on the financial markets and the real economy proved to be not so significant. In this regard the recent death of Kim Jong-il had similar overtones echoing the death of Kim Il-sung in 1994. However, a number of reasons suggest that the latest North Korea-related risks might not end as a single incident but linger as a latent long-term risk.
If we first look at the current economic conditions affecting North Korea, the situation is similar to those in 1994 in that both periods are punctuated with serious economic difficulties and recessions. In the 1990s, the closed system of Kim’s ruling had devastated the North Korean economy.

In recent years, however, sustained international economic sanctions, food shortages, currency reform failures, and the tight control exerted over domestic markets all led the North Korean economy to hit rock bottom. So any attending difficulties visiting the economy in addition to all other factors could very well tip the country into political instability.

Considering the political aspects, risks associated with the power succession that is currently taking place will ultimately unfold. This is noticeably different from the period after the Kim Il-sung regime. From the time Kim Jong-il was named the “legitimate successor” in 1974 to Kim Il-sung’s death in 1994, Kim Jong-il had twenty some years to establish himself through his supporters in the party and the military.

Yet, Kim Jong-Un, who was officially pronounced the legitimate successor in September 2010, has been paying much of his attention on stabilizing his succession and has not been able to eliminate the possibility of political instability and risks due to the limited preparation time that he has had.

From the South Korean economic point of view, the current situation is more vulnerable to the North Korea risk than the time of Kim Il-sung's death. In the early 1990s, the global recession hit the South Korean economy, which led to sluggish exports and the phenomenon of the “three lows” ― low interest rates, low oil prices, and low exchange rate.

However, the recovery in domestic consumption and construction investment enabled a return to stable economic growth. In contrast, today, Korea’s overall economy has slowed from the eurozone's fiscal crisis and the sluggish U.S. economic recovery, which hurt exports and weakened domestic demand. As a result, unlike the early 1990s when domestic demand was an impetus for economic growth, the real economy may contract and become seriously affected if the North Korea risk persists.

South Korean financial markets may also exhibit more volatility due to the rising impact of foreign investors, which is a new development since the mid-1990s. When the equity market was liberalized in 1992, the number of foreign investors’ KOSPI-listed holdings was minimal, taking up a little over 10 percent at the time of Kim Il-sung's death.

But today the shares by foreign investors have shot up to some 30 percent of market capitalization and over 6 percent in the bond market. Therefore, an increase in country risk caused by North Korea issues could trigger a capital flight of foreign investors and destabilize Korea’s stock and FX markets.

Even though the recent North Korea risk poses new problems, the financial markets have been quite stable. The problem lies in the coming days. Since the power transition and subsequent succession process may take longer and proceed less smoothly than expected, the recent North Korea issue might linger for quite some time while volatility is expected to rise in the financial markets with any negative news that might be forthcoming.

Consequently, we should take into account all potential risks related to North Korea and focus more on risk management to cope with any events on the horizon.