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Standard & Poor’s Ratings Services claims that the threat issued by

  • North Korea to restart its Yongbyon nuclear reactor and continue enriching uranium in other undisclosed locations has heightened geopolitical risks in North Asia. This tension has been further exacerbated by North Korea pulling out from the nuclear weapons non-proliferation treaty and an announcement that, if the US attempts a naval blockade of North Korea’s ports, Pyongyang will withdraw from the armistice of 1953, technically returning the country to war. The stakes are high in Pyongyang’s game of brinksmanship.

    Standard & Poor’s believes, however, that these threats are predominantly rhetoric aimed at extorting aid from South Korea, Japan, and the US, and at forcing Washington into direct bilateral negotiations, something the US is opposing.

    “The sovereigns most affected by this heightened geopolitical risk are South Korea and Japan. Ratings on both sovereigns assume that the rhetoric will not end in a military conflict and that North Korea will not suffer an imminent economic collapse that would precipitate peninsular reunion”, says Takahira Ogawa, Asia-Pacific director of Standard & Poor’s Sovereign Ratings Group.

    South Korea (local currency rating A+/Stable/A-1, foreign currency rating A-/Stable/A-2):

    If a military conflict is avoided, there are two likely outcomes. The first scenario, which is Standard & Poor’s base scenario, is that a peaceful, face-saving compromise will be found to reduce the current tension. The compromise might be brokered in an international forum. It would surely require sufficient aid for North Korea to prop up its teetering economy. In exchange, North Korea might agree to forego exporting its armaments to non-governmental entities or hostile states. The desire of the US not to be diverted from events in Iraq would facilitate such an outcome.

    The second scenario, which is also peaceful and consistent with South Korea’s ratings at the current levels, would entail a continued standoff with North Korea over its nuclear programme. South Korea’s foreign policy with North Korea might become even more difficult, due to North Korea’s improved bargaining power. However, such an outcome would not vary too much from the balance of power that has existed on the Korean peninsula for half a century. Security risks would remain high, but the cost of eventual reunification from the collapse of North Korea would be forestalled.

    The third scenario would entail a military outcome to the current impasse. Such an outcome would be short-lived and end in a regime change in North Korea. However, it would exact an intolerable human cost, particularly on the two Koreas. The fiscal costs of reconstruction on both sides of the demilitarised zone would be immense. South Korea’s sovereign rating does not incorporate such a negative scenario into its current level.

    Based on Standard & Poor’s main case scenario, there is no material increase of geopolitical credit risk to Japan from the threats issued by North Korea. However, Japan will have to reevaluate its commitment to military spending, and this fiscal burden, without compensating measures, could affect Japan’s sovereign ratings.

    As in 1998 and 1993, with tests of long-range missiles and echoed the day before yesterday with the firing of an anti-ship missile into the Sea of Japan, it is possible that North Korea could again launch a ballistic missile at or over Japan or South Korea, which may or may not be intended to land on Japanese or South Korean territory. Such a provocative ballistic test is more a real threat than the rhetoric of a peninsular Armageddon and Japan’s anti-ballistic defences cannot shoot down a missile before it reaches Japanese territory. Nor can Japan take the offensive, as the country’s constitution prohibits preemptive attack unless there is a material risk of foreign intention to attack the country. Notwithstanding ideological arguments from the minister of defence and certain sympathetic Japanese politicians, Japan is likely legally bound to inaction in the face of such threats. Besides legal constraints, Japan’s armed forces lack training and equipment to attack, and have not developed adequate coordination strategies with the US military to deal with any potential missile attack aimed to Japan. North Korea understands this weakness and has exploited it with missile launches over Japanese airspace. At that time, Japan could do nothing but temporarily freeze economic aid to North Korea.

    The need to improve its military preparedness might lead Japan to increase its defence budget spending in the years to come. These outlays would include the development of the Theater Missile Defense System, which Japan has agreed to underwrite with the US. But there is a government guideline to limit total spending for the defense within 1% of GDP, which could limit the pace of the expansion of the budget.

    In addition to ramping up spending to address the threat from North Korea, Japan will likely pay for part of peacekeeping costs after a war in Iraq. These added fiscal expenditures, without equal cuts elsewhere in the budget, will further strain the already weak fiscal position of Japan and place its ratings at risk.