RISKY
BUSINESS Crapshoot in
Korea By Jephraim P Gundzik
South Korea's stock market and exchange
rate have performed exceptionally well over the
past 18 months despite consistent deterioration in
the country's investment fundamentals. Resolution
of the North Korean nuclear issue has become
increasingly improbable in the medium term.
Economic growth has steadily weakened and
corporate profits have collapsed.
Rather
than fundamentals, the stellar performance of
equities and the exchange rate have been driven by
ultra-loose domestic and regional monetary
policies. With more bad news on the horizon and
monetary policies in South Korea and China rapidly
tightening, a very sharp
correction in asset prices and the exchange rate
are likely over the next six months.
Pundits rejoiced in September when
six-party talks on North Korea's nuclear program
appeared to have reached a breakthrough. However,
less than 24 hours after reaching this
"breakthrough", Pyongyang distanced itself from
its commitment to dismantling its civilian and
military nuclear programs. Two weeks later,
Washington imposed financial sanctions on North
Korea, setting back the six-party talks several
years. Investors turned a blind eye toward this
monumental setback.
The sharp reversal in
the course of the six-party talks continued in the
initial months of 2006, with Washington refusing
to end its sanctions and Pyongyang refusing to
return to the negotiating table. The increasingly
confrontational character of relations between
Washington and Pyongyang is apparent. In
mid-April, US assistant secretary of state
Christopher Hill described US sanctions against
North Korea as "life in the big city". North
Korean nuclear envoy Kim Kye-gwan responded by
saying Pyongyang would adopt an "ultra-hardline
manner" against Washington unless its sanctions
against North Korea were dropped.
Though
intransigent positions in both Washington and
Pyongyang have clearly led to the collapse of the
six-party talks, most analysts and investors have
failed to grasp the implications of this for South
Korea. Instead, these analysts and investors are
treating the North Korean nuclear issue as if it
were resolved and spontaneous harmony has erupted
between Washington and Pyongyang. These folks will
be mighty surprised when North Korea conducts a
nuclear test in the not too distant future.
Since the six-party talks were initiated
in August 2003, North Korea has steadily ramped up
its military nuclear program. It has harvested a
significant amount of plutonium from its nuclear
power plant at Yongbyan and conducted numerous
short- and long-range missile tests. Early last
year, Pyongyang announced that it had produced a
handful of nuclear warheads for its missiles. With
the six-party talks having reached an
insurmountable impasse, North Korea can be
expected to continue work on its military nuclear
program. However, this program has now become so
advanced that it faces only one more hurdle - a
nuclear test.
The inevitable North Korean
nuclear test will have grave consequences for
South Korea's economy. Washington will almost
certainly respond to North Korea's nuclear test
with an amplified military presence in Northeast
Asia. The movement of more US military assets into
the region will further escalate tension between
Washington and Pyongyang, raising fears of
military conflict between the US and North Korea.
Such fears will produce a quick and sharp collapse
of private consumption and investment in South
Korea. Fear of war will also encourage substantial
domestic and foreign capital flight from South
Korea.
The forgotten
fundamentals Investors also appear blind to
South Korea's weak and deteriorating economic
fundamentals. The country's real gross domestic
product (GDP) growth slowed to 4% in 2005 from
nearly 5% in 2004. The slowdown in economic growth
was driven by decelerating manufacturing growth,
which slowed to 7% in 2005 from more than 11% in
2004. Weaker growth in manufacturing was reflected
in much slower export growth, which plummeted to
12% in 2005 from 31% in 2004.
Loose
monetary policy in South Korea helped push real
private consumption growth up by 3% in 2005, but
real investment growth remained anemic at only
2.5%. The only seemingly bright spot in South
Korea's economy in 2005 was the decline in
consumer price inflation to 2.7% from 3.6% in
2004. However, the decline of inflation came at
the expense of corporate profits, because South
Korean companies have been unable to pass rapidly
rising energy prices on to consumers.
According to national accounts data
released by the central Bank of Korea in
mid-April, the operating surplus of South Korean
companies increased during 2005 by a mere 0.5%, in
nominal terms. In real terms, the operating
surplus, or net profits, of South Korean companies
contracted by more than 2% in 2005 from 2004. This
marks the weakest growth of corporate profits in
South Korea since the central bank began tracking
such data in 1970. By comparison, the operating
surplus of South Korean companies increased by
1.3%, in nominal terms in 1998 when the Asian
financial crisis was raging.
In addition
to the inability of South Korea's companies to
pass on skyrocketing energy prices to consumers,
exchange-rate appreciation severely undermined the
profits of Korean exporters in 2005. A turnaround
in profit growth is unlikely this year. Extreme
global geopolitical risk and robust energy-demand
growth in many countries during the first half of
this year will push international oil prices well
above US$100 per barrel. This will ensure that
energy and raw-materials expenses for Korean
companies continue to surge upward.
Declining global demand for South Korea's
export products in the second half of this year
and falling prices for its exported electronic and
computer-related goods will slow export growth
further. As soaring world energy prices push
profits and export growth lower, rising tension
between Washington and Pyongyang will sharply
reduce private consumption and investment. By the
second half of 2006, real GDP growth in South
Korea will turn negative, leaving economic growth
well below 2% for the year. The probability of
real economic growth contracting is greater than
the probability of real economic growth exceeding
3%.
It's impossible to reconcile the
performance of South Korea's equities and exchange
rate over the past 18 months with the steady
deterioration in the country's investment
fundamentals. In 2005, South Korea's KOSPI index
leaped 60% higher - Asia's best performer. This
year, the KOSPI has set numerous record highs. The
collapse in profits in 2005 and the continued weak
outlook for profits this year imply that excessive
liquidity is driving equity prices higher.
Similarly, the strong deceleration in export
growth - deceleration that will continue this year
- points to speculation as the driving force
behind the won's appreciation against the yen in
2005.
The primary source of excess
liquidity that is driving equity prices higher in
South Korea is Japan's ultra-loose monetary
policy, known as quantitative easing. Quantitative
easing has flooded Japan's banking system with
excess liquidity since late 2003. As this
liquidity improved the weak financial condition of
Japan's banks during 2004, foreign banks and
speculators began to borrow yen at near-zero
interest rates to invest in other countries. By
the end of 2005, much of Japan's excess liquidity
had found its way into other countries, especially
South Korea, as indicated by the won's 16% gain
against the yen.
At the same time, low
inflation in South Korea, compressed by the
absorption of rising energy prices by its
companies, allowed the Bank of Korea to keep
domestic interest rates quite low. As with Japan's
excess liquidity, South Korea's excess liquidity
was shunted away from fixed investment in
productive capacity toward speculative
investments. Thus both Japan's and South Korea's
excess liquidity inundated the Korean stock market
in 2005 and the early months of 2006. Both of
these liquidity taps will be turned off over the
next few months.
In early March, the
central Bank of Japan announced that it would
accelerate the withdrawal of excess liquidity from
the Japanese banking system - a process that
should be completed by the end of June. This will
dramatically reduce the availability of cheap yen
loans for foreign banks and speculators. At the
same time, much higher international oil prices
will push South Korea's inflation rate higher,
forcing the Bank of Korea to tighten monetary
policy.
Tighter monetary policies in Japan
and South Korea will further fuel sharp
corrections in the latter's equity prices and
exchange rate, which will already be reeling from
the effects of a nuclear test in the North and
rapidly weakening economic growth in the South.
Jephraim P Gundzik is president
of Condor Advisers Inc. Condor Advisers has
provided investment risk analysis to individuals
and institutions worldwide since 1995.
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