Economic fall-out from North Korean test

The economic fall-out from the North Korean nuclear test may show the vulnerability of other big Asian economies.

The North Korean economy is relatively small, with a GDP of around $15bn, and trades very little with the rest of the world.

Its main trading partner is China, and it has recently attracted some investment from the giant Korean firm Hyundai.

North Korea's state-run agricultural system has collapsed, and it depends on international aid and "unconventional trade" in arms for much of its income.

Its weak economy may make it vulnerable to economic sanctions that might be imposed as a result of the country's nuclear test, but its small size means that any move against North Korea would not have any economic implications for the rest of the world.

"(The crisis could) carry profound economic effects should disagreements over North Korea contribute to a deterioration in China's economic relationships with the US, Japan and the EU "
Marcus Noland, Institute for International Economics

But North Korea's location - in the centre of a region of dynamic economic growth, encompassing China, Japan, and South Korea - means that any political fall-out from the tests could directly impact on neighbouring countries.

So far financial markets have reacted with caution to the political crisis, with relatively limited falls in Asian stock markets, helped by the fact that Japan was closed for a holiday.

But there are big potential economic risks in the situation.

South Korea

The country that could be most vulnerable in the event that political tensions escalate could be South Korea.

In contrast to the North, South Korea is an economic powerhouse, with an economy of $680bn - larger than Russia or the Netherlands.

It is also one of world's dozen biggest exporters, with 35% of its economy made up of internationally traded goods. It is a leading exporter of electronic goods, cars, steel, ships, and semi-conductors.

South Korea has made a strong recovery from the Asian economic crisis in 1997-98, when its currency fell sharply and economic growth collapsed.

And since then, it has increasingly opened its economy to foreign investment, which makes up 40% of the investment in the stock market.

The country has also accumulated large foreign currency reserves of more than$200bn.

However, some observers believe that South Korea could be vulnerable to a sharp downgrade by foreign investors if the crisis escalates.

Marcus Noland, of the Washington DC-based Institute for International Economics, argues that investors are likely to downgrade assets denominated in South Korea's currency, the won, and increase the "risk premium" - demanding higher interest rates before they invest further in Korea.

This could affect both the stock market and the currency market, and slow economic growth in South Korea further.

Mr Noland suggests that South Korea might also re-impose emergency capital controls to stem further outflows, which could reverse some of the recent liberalisation.

But he suggests that these economic consequences, although negative, would not be "cataclysmic" if the Korean authorities respond promptly to the increased risks.

Japan and China

Japan - just across the sea from Korea - is an even bigger player. Its GDP of $4 trillion makes it the second biggest economy in the world.

Japan could also be threatened by North Korea military action, and its stock market is now 25% owned by foreign investors.

But the Japanese government also has huge currency reserves which could be used to support the stock market, as it was in the 1990s.

However, unrest in the Korean peninsula could shift the pattern of Japanese foreign investment southwards towards south-east Asia, and lead to a remilitarisation of the Japanese economy.

And Japan's economy is just recovered from a prolonged economic downturn which stemmed from the collapse of land values and the stock market.

Japan is also a very large investor in the fast-growing Chinese economy.

China also has a direct interest in the crisis, and has perhaps more leverage on North Korea than any other country.

China's economic growth has been driven by foreign investment and access to foreign markets in the US and Europe, while its currency does still not float freely on international markets.

But there is a danger, according to Mr Noland, that the situation could "carry profound economic effects should disagreements over North Korea contribute to a deterioration in China's economic relationships with the US, Japan and the EU - the three markets with which China's continuing economic success (and internal political stability) are inextricably linked".

Some analysts believe that the economic effects would be limited unless there is further escalation.

"The regional impact won't be very significant unless there is a major military confrontation," says Wang Qing, an economist at Bank of America in Hong Kong.

But given the huge likely economic knock-on effects of a major crisis in Asia, which is at the dynamic heart of the world economy, the wider risks of an escalating conflict must be taken seriously.

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