Fears over ‘black swan’ moment emerge in Korean financial market

Moral hazard of market analysts on North Korean threat possible

By Cho Jin-seo

An ominous indifference is spreading in the financial market toward the military conflict with North Korea.

Some think that there is widespread public apathy toward security, particularly the risk of Korean War II, just like the American investors had been complacent before the bubbly subprime mortgage market.

Since Tuesday, stock prices have fallen, but the movement was so marginal that it is difficult to believe the escalating military tension out on Yeonpyeong Island had particularly any impact on the market.

The KOSPI index ended at 1900.5 on Friday, down by only 1.47 percent since Tuesday, but the performance matched other major Asian stock indices.

People in the stock and bond market think that they have learned enough from previous experience that there will never be a full-scale war on the Korean peninsula. But this complacency can be dangerous, says a high-ranking official at the Ministry of Strategy and Finance.

“It seems that the people in the financial market are thinking (North Korea) is crying wolf,” he told The Korea Times on Friday. “That raises worries about what will happen to the market if the wolves really come down, though, of course, that should not happen in reality.”

The official has been on the government’s 24-hour financial market monitoring team since Tuesday, when the North’s artillery fire destroyed scores of houses on the island and left two marines and two civilians dead.

The South Korean military fought back with its cannons and now it launched a joint naval exercise with an American aircraft carrier Sunday, near the maritime border.

But unlike the furious reaction from the defense ministry, the finance ministry, Bank of Korea and Financial Supervisory Service are working on the contrary, as they try to assure foreign and domestic investors that Korea is a safe place to invest in and do business with and the conflict will have “limited” impact on the economy.

Their efforts to calm the financial market worked out well, probably too well. The three large credit-rating agencies _ Standard&Poors, Moody’s, Fitch _ all maintained their investment grades on Korea despite the attack.

“Our assessment remains that the robust state of the ROK-US military alliance and China's interest in stability on the peninsula will deter Pyongyang from taking even more reckless provocations, possibly leading to war,” said Moody’s analyst Tom Byrne, after his firm was contacted by government officials. “...... we believe that South Korea's strong credit fundamentals continue to support the government's A1 rating and that the outlook remains stable,” he said.

They were not alone in sharing confidence in the national security of Korea, as most stock brokers released reports saying the incident only adds to short-term volatility.

But there are a few worried souls who think foreign investors should think twice about this cheerful optimism of rating agencies and local brokers.

A Black Swan event

“It reminded me of the Black Swan and the subprime mortgage crisis,” said Park So-yeon, macroeconomic analyst at Korea Investment & Securities. "The Black Swan; The impact of the highly improbable" is a book by Nassim Taleb, in which the author says that people have a tendency to ignore the risk of events with a low probability and a very calamitous consequence.

“Many people in the market say that it would be okay, because it was okay in the past. But I beg to differ. This time is different from the past. In this case, we cannot predict the future based on experiences of the past,” she says.

Park, who studied East Asian history before joining the stock industry, says that the current conflict will have a more long-term impact than most analysts and the government insist, because it reveals growing uncertainty inside the North Korea regime and it is taking place as the relationship between the “hermit kingdom” and the U.S is deteriorating.

There are a few other theories on why the financial market has been so calm despite the gunfire.

The senior official at the finance ministry says that some now view the inter-Korean relationship like that of Palestine and Israel, where violence has continued for decades so financial investors no longer react to a single conflict.

Psychology can be a factor. Robert Kelly, professor of international relations at Pusan National University, says that “South Koreans just want to forget about NK.”

“They don’t want their wealthy comfortable democracy trashed in a war with a ruler they consider a quack. So South Koreans just put up with this stuff. Their tolerance for NK pain is quite high, because the costs of war and reunification are frightening. Also, South Korea’s hands are badly tied by the extreme exposure of SK population centers to NK retaliation,” he writes on his blog.

Park, the Korea Investment & Securities analyst working in the financial district of Yeouido in Seoul, suggests a more practical factor on why people in the financial industry are seemingly irrational in playing down the risk of a full-scale war _ it’s because they do not have an economic incentive in talking about war.

“Well, for stock market analysts, this is an all-or-nothing situation. If war really breaks out, then we have to run out of the office as fast as possible to save our lives, and the market will no longer mean anything to us,” she says. “So there is no meaning in speaking on how serious the situation is. This is in sensitivity toward security.”

So it is logical for the stock brokers and analysts to underestimate the risk of war not only because the probability is low but also because they have no interest in a war, Park says.

But unlike the rating agencies that had put triple-A ratings on doomed subprime mortgage bonds, one cannot blame the Korean stock brokers for a lack of ethics since they at least hope for peace, and can contribute to it by influencing the government.

북조선과의 군사분쟁에 대한 불길한 무관심이 금융시장에 퍼지고 있다.

어떤이들은 제2차 한국전쟁에 대한 집단적 불감증이 모럴헤저드를 보여주는 것이 아닌가 생각하고 있다. 마치 서브프라임 시장 붕괴 이전의 미국처럼.

화요일 이후 주가는 떨어지고 환율도 올라갔지만 그 움직임은 너무 작아서 연평도 사건이 시장에 큰 영향을 주고 있다고 보기는 힘들다. 코스피 지수는 화요일 이후로 1.47퍼센트 떨어졌는데 이는 다른 아시아 주요국가 증시의 움직임에서 크게 벗어나있지 않다.