What happened?
North Korea escalated the crisis with the US, Japan and South Korea over the weekend with another nuclear test. It supposedly had a yield of 100 kilotons, 10 times the power of the nuclear test done a year ago. Ahead of the explosion, North Korea launched a video showing Kim Jong-un around what was stated to be a nuclear warhead capable of being mounted on an Intercontinental Ballistic Missile (ICBM). North Korea tested two ICBMs in July that were deemed capable of reaching the US.
A nuclear test has been one of the ‘red lines’ that the US has mentioned would trigger action. See our piece earlier this year, Research: The rising risk from North Korea – and what it means for markets, 27 April 2017
US President Donald Trump and his administration reacted strongly, indicating still that a military option is on the table and looking for North Korea to be isolated from trade. One option mentioned by the administration was to not trade with any country that has trade with North Korea.
The market impact was relatively muted overnight: Asian bourses are mostly lower by close to 1% but the Chinese onshore market is up slightly. The market does not seem to expect the crisis to escalate into war and previous escalations have only had shortlived market effects.
Our quick view
While the nuclear test is a further escalation, we still see war as a low probability outcome as the effects would be detrimental. The US Defence Secretary James Mattis said earlier this month that a war with North Korea would be catastrophic.
However, whenever brinkmanship is in play there is always a risk that some error will occur and things get out of hand with a tit-for-tat pattern. However, none of the parties in the conflict has an interest in war. North Korea is likely to be feeling threatened by the US and South Korea given the rhetoric of ‘all options on the table’ and military games going on between them. Hence, Kim Jong-un’s response has been to show the US that North Korea would meet any military strike with a significant response and indicate that it has the capability of reaching the US as well with a nuclear warhead.
On the other hand, the US and South Korea aim to show North Korea that any misstep from the latter could lead to total annihilation of the regime. James Mattis said on Sunday that the US was not planning for the ‘total annihilation’ of the rogue regime even though it has ‘many options to do so’.
What’s next?
It is of course hard to predict and we are by no means military analysts. However, our view is still that we will see a continuation of regular escalations but with a low probability of war.
The US is likely to aim to isolate North Korea and cut it off from trade completely. They may not get full backing for this from China and Russia and we could see increasing tensions between the US on the one hand and China and Russia on the other. The risk of US trade sanctions on China is increasing. This would have a negative impact on both the US as well as the Chinese economy, and thus the global economy.
We do not expect North Korea to back down from its nuclear ambition. It simply sees the nuclear deterrence as the only guarantee of the regime’s survival from a US attack. Sanctions are not likely, in our view, to stop North Korea. At the same time, there is no easy solution for Trump to stop North Korea. The crisis is likely to continue for some time. While Trump said last week that ‘talking is not the answer’, it is hard to see how North Korea can be stopped militarily and through sanctions. For now though, Trump aims to show that his military threat is credible – even if it is not.
