Historical context
The year 2017 has been rich on events that shocked and scared the world: a chain of terrorist attacks in Europe, an undamped flame of war in the Middle East, devastating hurricanes in America and disastrous landslides in Asia. Though probably one of the most memorable and significant events, from the point of view of global security, was an escalation of tensions between North Korea and the United States.
Since the end of the Korean War in 1953, the countries had a very uneasy relationship. Differences were too large: democratic state system versus socialistic state system, advanced industrial market economy against isolated agrarian mixed economy, multi-ethnic population in contrast to mono-ethnic population and, finally, dissimilar views on fundamental human rights and the rule of law. In addition to that, development of healthy relations between the two states has always been hindered by the nuclear programme of North Korea.
The issue dates back to early 1980s when North Korean scientists and military started to operate facilities for uranium fabrication and conversion and later conducted a number of detonation tests. At that time, the international community managed to find a mutually acceptable solution and in 1985 North Korea signed and ratified the Non-Proliferation Treaty. Unfortunately, reports that the government submitted did not always match with findings of the International Atomic Energy Agency's inspectors. Consequently, this diplomatic achievement did not bring a desired effect and eight years later the North Korean government unilaterally decided to withdraw from the agreement.
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A new attempt to find a compromise was made by the Clinton administration when the two countries signed the Agreed Framework, under which the United States pledged to provide two light water reactors in exchange for North Korean nuclear disarmament. But due to opposition in the establishment of both countries and other political obstacles, the agreement has never been fully implemented. The last hope disappeared when George W. Bush took the Office and named North Korea a part of the Axe of Evil. As a result, in 2002 the Agreed Framework was officially terminated and in 2003 North Korea once again declared the withdrawal from the Non-Proliferation Treaty.
Such outcome forced all interested parties to look for another solution, which was found in the form of six-party talks that took place between 2003 and 2007 with the participation of Russia, China, Japan, North Korea, South Korea and the United States. The first two rounds did not bring any notable result. During the third round of talks, North Korea agreed with the proposal to freeze its nuclear facilities in exchange for fuel supplies and further normalisation of relations with regional powers. However, then it decided to postpone the talks due to South Korean uranium and plutonium secret development issue.
In 2005, members of the working group renewed negotiations and eventually adopted the Joint Statement on denuclearisation principles, where North Korea agreed to cancel all nuclear programmes and return under supervision of the IAEA in exchange for the right to continue to use nuclear energy for peaceful purposes and normalisation of relations with the United States and Japan. But these intentions were compromised after the US Ambassador to South Korea Alexander Vershbow made inappropriate remarks about the North Korean government. Shortly after this incident as well as imposition of new sanctions by the United States on North Korean companies, the latter de facto denounced its previous promises.
In subsequent years North Korea conducted two tests, including the unsuccessful satellite launches, which were unanimously condemned by the international community. After another vote in the United Nations Security Council where all members supported an intention to impose new sanctions, North Korea decided to leave the six-party talks and declared resumption of the nuclear programme.
In 2011, Kim Jong-il died and his post was transferred to Kim Jong-un who continued to develop the nuclear programme started by his grandfather. In the following two years, under the new supreme leader North Korea managed to successfully launch an Earth observation satellite as well as to conduct a third nuclear test. Both events expectedly caused international condemnation. Last year, North Korean scientists conducted another two underground detonations, one of which was declared to be an explosion of a hydrogen bomb.
Discrepancy
The above historical context to a certain extent explains why Donald Trump concentrated his foreign policy on the crisis surrounding the Korean Peninsula. Certainly, a great role in shaping of this vision played the Chief of Staff General Kelly, the National Security Advisor General McMaster and the Secretary of Defence General Mattis. However, there is a need to take into account that increasing external pressure, such as sending a fleet of warships into the Sea of Japan, will only stimulate North Korea to more actively develop its defensive capabilities.
Chart 1: USD/JPY changes during ballistic missile tests on (1) July 28, (2) August 25, (3) August 28, (4) September 14
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Indeed, just over the last eight months North Korea conducted 14 ballistic missile tests plus the sixth nuclear test. Some of them were not successful. But the remaining perfectly illustrated North Korean achievements in this area. On February 11, they managed to launch a solid-fuelled missile from a mobile launcher for the first time. On March 5, the fired missiles flew more than 600 miles and landed into Japan's economic exclusion zone. On May 14, the fired missile set a new record high by reaching an altitude of 2,000 km and landed less than 100 km from the Russian border. On July 4, North Korea successfully launched the first two-stage intercontinental ballistic missile. On July 28, they fired the same type of missile, which landed 150 km from the island of Hokkaido. However, on September 14 another fired missile has already entered into the Japanese airspace and flown over Hokkaido. In addition to that, on September 3 North Korea said it successfully tested a hydrogen bomb, which created a 6.3 magnitude tremor.
In essence, this timeline indicates that North Korea has de facto joined a group of states that possess nuclear weapons. Moreover, these aggressive tests indicate that the North Korean leadership is going to continue building up nuclear capabilities. Such status implies another two conclusions. First, despite all hostile rhetoric, the United States will not dare to attack North Korea first. Second, in the worst case scenario, the first two countries that will bear an irretrievable loss would be South Korea and Japan. In this regard, it should be noted that for this purpose the use of nuclear weapons is not even necessary, as Seoul, a city with a population of 20 million people, can be quickly destroyed by conventional weapons. Thus, both countries are continuously experiencing a threat to their national security, which increases even more with every new missile test.
Chart 2: USD/JPY compared to XAU/USD (with highlighted missile tests)
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On the one hand, the perspective a new war on the Korean Peninsula with the use of nuclear weapons seems very unlikely. On the other hand, there is a historical precedent, which involved the same countries in a similar configuration. In additional to that, there is an experience of use of nuclear weapons against the enemy. Hence, a small, but nevertheless a possibility exists. Accordingly, if the risk is real, it should have some practical implications.
In this case, valuation of the Japanese Yen presents an interesting example of how financial markets interpret this threat. Generally, the value of each currency tends to reflect the state of national economy. The more prosperous and stable it is the more demand for its currency is. In contrast, reports about high unemployment, insufficient consumer spending and increasing indebtedness make national currencies less attractive. Fortunately, Japan has one of the largest economies in the world that is characterised by competitive exports, technologically advanced industry and highly qualified workforce. These and other factors helped the country to successfully survive many economic and political crises.
By logic, a direct and constant nuclear threat should not lead to the appreciation of the Yen because in case this risk materialises, the currency will lose its basis. Until a certain point, such assumption remained hypothetical. However, the recent flight of ballistic missile over Hokkaido made this risk more than possible. To put it differently, what is the probability that due to a technical failure the next fired intercontinental ballistic missile would not fall to Sapporo, the fifth largest Japanese city with the population of almost two million people? There is a need to take into account that there were many cases when launched missiles did not reach their target and exploded during the flight. Why could not a similar situation repeat over populated areas next time? For this reason, the question remains why the Japanese Yen continues to gain value against the American Dollar and other major currencies?
Widespread explanation
The common answer is that the Yen has a well-established reputation of a safe haven currency. Such title is mainly based on the status of net overseas investor, which means that the Japanese hold most of their funds in foreign assets. In particular, Japan holds $111.3B, or 17.8%, of the US sovereign debt, which makes it the second largest foreign debt owner. This number reveals how both countries are financially dependent on each other.
Accordingly, if there is a threat to the US financial stability, Japanese investors will have an opportunity to quickly transfer their funds from foreign into domestic assets and in this way strengthen the national currency. However, in the opposite scenario the situation would be a little bit different. If there is a threat to Japan's national security, local investors will either leave or transfer their funds from domestic into foreign assets. In this case, the value of the Yen has to either stay unchanged or decrease.
Nevertheless, the Yen continues to appreciate against the Dollar and not vice versa. From this perspective, it seems that investors are more concerned about safety of the United States and not Japan or South Korea. This way of thinking is illogical, as the United States has much more defensive capabilities than its allies, and, as it was previously mentioned, there is a need remember that in case of a real conflict, regardless of who started it the first, the two countries that would be hit first are South Korea and Japan. However, do traders always act rationally?
Alternative explanation
The answer to the question put forward would be: not always. Though there might be a more pragmatic thinking than it seems. There is a high chance that sophisticated investors with control of large financial resources and access to state officials who possess sensitive information do not consider the war with the use of weapons of mass destruction as an option at all. Similar scepticism might also dominate at the retail level. The only difference is that this thinking is based not on deep understanding of the issue but rather on absence of such knowledge and, as a result, underestimation of the risks.
In 2012, Shinzo Abe became the new Prime Minister of Japan and his Liberal Democratic Party regained control over the government. One of his priority focus areas became the build-up of military power. In particular, he started to annually increase defence budget, which in 2016 reached $43.66M, thus setting a new record high. Two years ago he even managed to lobby a law that allowed Japan's Self-Defence Forces to participate in overseas conflicts.
For a certain part of the society this was more than a radical move because Japan has not been participating in military actions since the end of the World War Two. The reason behind such peaceful foreign policy is based on Japanese constitution that was prepared by the United States in 1946. It contains a famous clause, which disowns war as a sovereign right. This means that Japan cannot maintain "land, sea, and air forces, as well as other war potential".
However, in practice this rather means that Japan has a restriction on a number of active military personnel and acquisition of offensive weapons, such as intercontinental ballistic missiles, aircraft carriers and bombers. These limited defensive capabilities have at least two crucial implications. First, Japan, in contrast to Israel, is deprived of the opportunity to make a pre-emptive strike in case of direct and inevitable threat to its national security. Second, for many years it has been forced to share concern about its safety with the United States. This delegation of sovereignty results in 40K of the US troops serving on 112 military sites, including the Yokosuka naval base that stations the 7th fleet.
In terms of economics, this partnership means that Japan's Ground, Maritime and Air Self-Defence Forces in large part are equipped with weapons produced by the American military-industrial complex. It does not apply to armoured vehicles and small arms, as this market is dominated by Toshiba, Mitsubishi, Howa, Kawasaki and other local giants, but rather to more technologically -advanced and extensive type of weapons and their components. For instance, Kongo-class destroyers are powered by the Ishikawajima-Harima LM2500 gas turbines produced by General Electric and carry SM-3 anti-ballistic missiles produced by Raytheon and Aerojet.
It appears that the Article 9 of the constitution bears not only political but also significant economic consequences. So, there is nothing surprising in the fact that the current Japanese government wants to amend this part of constitution, thus creating a legal basis for the Self-Defence Forces and enlarging their rights. Although the current set of draft revisions does not envisage fundamental changes, it gives a clear impression of a new trend and in larger perspective might lead to more substantial consequences.
There is a need to notice that Abe's course has not only internal but also external rationale. Transformation of North Korea into a fully-fledged nuclear power equally forces Japan to acquire and develop proper means of defence and adjust its national defence strategy. In addition to that there is a threat from China's growing presence in the South China Sea, which also demands adequate military response from Japan. The key thing is that this rivalry will have a long-term effect. And it would not be possible to sustain in this opposition with the constitution and army that were designed for the realities of a cold war.
However, the major question remains whether Japan, facing these contemporary challenges, will manage to realise the above policy. To put it differently, the question is whether the Japanese government manages to withstand the pressure from the United States in the implementation of the above-mentioned policy. On the one hand, it looks very unlikely. On the other hand, the United States is currently facing a major political crisis that will only worsen in the upcoming years. This internal weakness might give Japan a chance to untie the hands of the army and start actively investing in its military-industrial complex that will produce instruments necessary for a successful response to threats coming from North Korea and China.
Accordingly, for those sophisticated investors who have a long-term investment plans each new nuclear test conducted on the Korean Peninsula might represent a sign of the correctness of their reasoning.
Conclusion
The main task of this article was to show inconsistency between the current geopolitical situation and its perception by financial markets. The recent series of missile launches showed that North Korea de facto became a new nuclear power.
On the one hand, this status practically excluded possibility of a new war on the Korean peninsula, as it might have unbearable consequences for all countries in the region. On the other hand, very hawkish rhetoric between the North Korean leader Kim Jong-un and the US President Donald Trump does not allow excluding this possibility at all. In other words, the risk of a war with the use of weapons of mass destruction still exists.
Given the military power of each interested party as well as geographic features, the first two countries that would suffer massive casualties in case of a hot conflict will be South Korea and Japan. This fact basically undermines Japan's status of a safe haven country. From another perspective, North Korea's continuous strengthening justifies Shinzo Abe's policy aimed at empowerment of the Self-Defence Forces.
The greater will the external threat be, the greater will be spending on defence, which in turn, presupposes acquisition, development and deployment of new type of weapons capable of effectively addressing contemporary threats. This way of thinking not only views Japan as a safe haven currency but also assumes an increase of its role in the region in the long run.