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South Korea: Between a Rock and a Hard Place

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As I've discussed previously, a key risk in the Asia game theater is that one of the less influential players does something to prompt a strong response from the U.S. or China. That's what we're starting to see with recent actions from North Korea drawing responses from the U.S. and China—and South Korea getting caught in the middle.

North Korea is increasing the frequency of its nuclear tests and missile launches, many of which coincided with meetings between the U.S. and others in the region. For example, North Korea fired a missile into the Sea of Japan when Japanese Prime Minister Shinzo Abe was meeting with U.S. President Donald Trump in February. In early March, North Korea fired several more missiles into the Sea of Japan as South Korea and the U.S. went through their annual military drills. Then, later in March, a North Korea missile test failed days after U.S. Secretary of State Rex Tillerson visited the region to meet with leaders from China, South Korea, and Japan.

South Korea is between a rock (North Korea's actions) and a hard place (U.S.'s and China's responses).

It's important to note that in addition to U.S. security commitments to South Korea and Japan, the U.S. has tens of thousands of troops stationed in each of these countries. So, U.S. security interests are also at stake.

U.S. and China Responses

In response to these missile tests, China is pushing back on escalation, with Chinese Foreign Minister Wang Yi calling on North Korea to stop its nuclear and missile tests and for South Korea and the U.S. to stop their joint military drills. Still, China separately announced that it is freezing coal imports from North Korea through the end of the year.

But the most important action to date is that the U.S. has started deploying the Terminal High Altitude Area Defense System (THAAD) in South Korea. THAAD is a missile defense system designed to intercept short- or intermediate-range ballistic missiles. It is more intended to protect South Korea from any missiles within its borders rather than knocking out any long-range missiles headed toward the United States, for example.

Several components still need to arrive for the missile defense system to be operational. Most estimates put that timeline at a few months.

At the same time, China strongly opposes the deployment of THAAD off the coast of South Korea as the missile defense system represents another set of U.S. radar on the doorstep of China.

China's response highlights how trade and security issues can get intertwined across the Asia game theater. To push back on the deployment of THAAD, China has initiated restrictions on its citizens traveling to South Korea for reasons related to tourism. After all, China is South Korea's biggest trading partner (including tourism), so these actions are significant from South Korea's perspective.

These developments affirm our current Asia game theater analysis and highlight South Korea's weakness. South Korea has less near-term endowment power—lacking a strong leadership position—and is between a rock (North Korea's actions) and a hard place (U.S.'s and China's responses). In addition, the recent developments show that the U.S.'s risk tolerance and salience is a bit higher in the region than it previously exhibited, partly because of the new administration, and partly given North Korea's actions.

Investment Implications

Our portfolio positioning aligns with our fundamental and geopolitical analysis. Fundamental valuation signals point to Asian emerging market equity markets being attractive, and in many cases we're long—and actually above the fundamental signal—in India, China, and Vietnam. But in South Korea, we're long—but below the fundamental signal—as a result of our geopolitical analysis.

On the currency side, we're currently long Asian currencies, such as the Chinese yuan, Philippine peso, and Vietnamese dong, and slightly short the Taiwan dollar and the Korean won.