Thoughts On The Two Koreas

by Win Thin

The won has been one of the worst performers so far today due to developments in the Korean peninsula.  Clearly, North Korea is trying to make a statement to the West with its recent saber-rattling, and reports of the failing health of North Korean leader Kim Jong-Il (age 69) means that there is a struggle behind the scenes as Kim tries to control the transition.   While any discussion about North Korea’s political landscape involves a huge amount of guesswork, it appears that Kim Jong Il‘s transfer of power to his youngest son Kim Jong-Un (age 27) may be turning out to be a bumpy one, requiring more hawkish behavior to burnish the son’s leadership credentials with Pyongyang’s military.  Besides this possible tension with the military, some believe that Kim Jong-Il’s brother-in-law Jang Song-Thaek (age 64) could attempt to wrest power from the younger Kim.  Recent behavior is erratic even by North Korean standards.

South Korea must be getting tired of these antics, but there’s not much it can really do.  Retaliatory artillery fire was seen, but Seoul rightfully does not want to get drawn into a deeper military conflict.  South Korea Defense Minister (a known hawk) signaled possible escalation in tensions this week when he brought up the possibility of asking the US to redeploy nuclear weapons on the Korean peninsula, something not seen since 1991.  US President Obama has sent his envoy Stephen Bosworth to the region to consult with officials in Seoul, Tokyo, and Beijing, but many feel that the US does not want to add to tensions by redeploying nuclear weapons in that volatile region.  It remains to be seen how engaged China will be, as it is struggling with domestic economic issues that is taking up the spotlight.

Short-term retracement levels to look for in USD/KRW are 1140, 1152, and 1164.  Usually, KRW bounces back quite quickly from any North Korea-related sell-offs, and we expect the same to eventually hold.   However, these moves by Pyongyang come at a time of extreme nervousness in the markets and so a significant KRW bounce may not be seen until 2011.  EM currencies are down across the board as risk off trading prevails in the face of Korean tensions as well as renewed pressures in the peripheral euro zone.  Indeed, we continue to feel that EM currencies have likely seen the highs for 2010 and that we are in a near-term EM bear trade through year-end.  Looking ahead to 2011, though, we believe that the fundamental divergences between developed and emerging markets will remain in play and so we are still positive EM FX longer-term.

Win Thin | Global Head Of Emerging Markets Strategy