North Korea: Crisis scenarios

FROM THE ECONOMIST INTELLIGENCE UNIT

Recriminations over the sinking of a South Korean naval vessel, Cheonan, with the loss of 46 lives have raised tensions on the Korean peninsula. Having officially blamed North Korea for the March 26th sinking, the South Korean government has announced an initial package of retaliatory measures. An incensed North Korea has responded by severing all ties with the South and by upping its now-customary belligerent rhetoric.

In response to the rise in tensions, the Economist Intelligence Unit in the following article outlines (and assigns probabilities to) three scenarios that could emerge from the current crisis. The scenarios are (1) symbolic punishments; (2) serious tightening of sanctions; and (3) significant military escalation. As far as foreign investors and the markets are concerned, the first is infinitely preferable, as it would see the current crisis stabilising into a status quo quite similar to that that existed before the sinking of the Cheonan. However, there is a significant chance of the alternative outcomes coming to pass that investors will need to take into account.

SCENARIO 1: SYMBOLIC PUNISHMENTS

We attach a probability of 70% to this outcome. Many of the gestures that would come under this category have already been implemented. Since the release of its report into the sinking of the Cheonan, the South Korean government has cut all bilateral trade other than that involving Kaesong Industrial Complex (KIC). (The North itself has subsequently warned that it would ban South Korean traffic to and from KIC, in effect shutting it off.) South Korea has also resumed anti-North Korea broadcasts along the North-South border. In late May, the South Korean government stated that it was willing to omit sanctions from any UN action against North Korea. This latter gesture is perhaps aimed at making it easier for China to agree to any UN initiatives that are attempted. Currently, it is likely that rather than seeking any tangible action through the UN, the interested parties will focus on gaining a UN agreement to “condemn” North Korea for the incident. The US and Japan are likely to seek a co-ordinated response with South Korea. Limited bilateral actions may be taken. For example, on May 28th Japan said that it would clamp down on money transfers from Japan that are destined for North Korea.

Potential impact: As many of the measures in scenario 1 are in place, this can be regarded in effect as a continuation of the current situation. While some businesses will clearly be affected, notably those South Korean companies that engage in trade with the North or that have operations in the KIC, in many other respects the steps taken so far are low-impact. The end result should be an environment for business that is not that far from the status quo—albeit with an added recognition of the dangerous unpredictability of the North Korean regime.

SCENARIO 2: SERIOUS TIGHTENING OF INTERNATIONAL SANCTIONS

Serious additional multilateral sanctions are among the least likely outcomes of the recent escalation. This is partly because, in the wake of the nuclear test in 2009, the international community has already imposed a relatively tight sanctions regime on North Korea. Exports and imports of all weaponry except small arms are banned. Further measures could be taken to restrict North Korea’s trade in minerals, such as its exports of iron ore or its imports of oil. But China is the only country that would really be affected by this—or indeed able to implement it. China’s co-operation would also be necessary for any tightening of restrictions on financial transactions involving North Korean parties (although any such measures are unlikely to repeat the success of the US-led effort to freeze US$25m of North Korean accounts in Macau-based Banco Delta Asia in 2005, as the North is better prepared for such steps now).

However, the Chinese government appears to have recently settled upon a strategy of deepening economic interaction with the North as a means to promote stability there. Reversing this would be politically difficult. While there is a small possibility that China could reverse its deepening of economic ties, perhaps if it were isolated on the UN Security Council (UNSC) in opposing serious sanctions, we remain doubtful that this will happen—especially as South Korea also now appears willing to not push for additional UNSC economic sanctions. We thus attach a low probability of 15% to this outcome.

Potential impact: If serious sanctions were put in place, few foreign businesses would be directly affected immediately except for companies engaged in existing or potential projects in the North. However, the sanctions would enhance the risk of regime collapse, so investors should assess what potential dangers and opportunities this could bring. On a positive note, regime change could ultimately open the door to massive investment opportunities in North Korea once a new government was in place. Nevertheless, these opportunities are clearly overshadowed by the very real risk that serious violence could either precede or accompany the decline of Kim Jong-il’s government, including the possibility of war. In addition, China’s north-east could receive a destabilising inflow of refugees, and face potential security challenges.

SCENARIO 3: SIGNIFICANT MILITARY ESCALATION

The South Korean government has already taken some measures towards military escalation, having resumed “psychological warfare” against the North and announced its participation in the Proliferation Security Initiative (a multinational naval operation aimed at blocking the spread of nuclear materials). The ban on North Korean vessels from Southern waters also represents a form of military escalation. There are a number of options should the South and its allies wish to take further steps in this direction. The US and South Korean governments could postpone plans to relocate US military forces away from the Seoul area. They could also push the UNSC to broaden the basis for searches of North Korean ships travelling in international waters. In addition, joint military exercises (involving South Korea and the US), which already occur regularly, could be stepped up further.

We attach a 15% likelihood to scenario 3. This mostly reflects the danger that the North Korean regime could adopt a military response of a much more aggressive nature—a risk that would increase in proportion to the actions that South Korea and its allies take. With North Korea’s motives for sinking the Cheonan unclear, it is simply impossible to tell whether Kim Jong-il’s government would view further aggressive moves as being in its strategic interest. The options available to the regime include conducting further nuclear or missile tests, or announcing an official acceleration of its nuclear programme. Nevertheless, within this 15% weighting, we continue to attach a relatively small possibility, roughly 2%, to the risk that the clashes could escalate into full-blown war. The North would be unlikely to instigate a full-blown conflict unless its political structure were imploding. It no doubt realises that it would ultimately lose any conflict—though not without first inflicting heavy damage on the South. For this reason, South Korea would be likely to use military force only in retaliation to the North’s starting direct military action. North Korea retains the capability to devastate large parts of South Korea.

Potential impact: A serious conflict would have damaging medium-term implications. In the first instance, South Korea’s industrial capacity could be destroyed (much if it is based within reach of North Korea’s armaments). Even if not decimated, South Korea’s key electronics sector would probably lose out to competitors in Taiwan and Japan, as domestic firms would in any event have difficulty producing goods. The damage to the broader economy would be felt through a dramatic fall in the prices of all types of assets and a sustained fall in consumer and investor confidence. Much would depend on how much damage would be done within the initial days of attacks by North Korea.