North Korea's Problem

In December, North Korea launched a satellite into orbit, which was a violation of U.N. resolutions against ballistic missile tests. Last month, it carried out its third nuclear test, which was apparently more successful than the previous two attempts. The U.N., with Chinese approval, approved additional sanctions on the regime.

The new sanctions triggered a veritable blast of rhetoric from the Hermit Kingdom, including nuclear threats against the U.S. Although it is highly doubtful that North Korea has built a nuclear warhead capable of re-entry and a missile that can reliably reach the continental U.S., it did prompt the Obama administration to shift some anti-ballistic missile units away from Europe to Alaska, where they will presumably offer protection for the U.S. mainland.

Belligerent statements out of North Korea are nothing new. However, with the “Young General” now in charge from his father, there is an element of uncertainty that did not exist previously. So the question becomes, “is there anything different here?”

In this report, we will examine the North Korean system, focusing on how a small, poor nation manages to operate surrounded by stronger and more economically advanced nations. We will also analyze the North Korean nuclear program and the likelihood of its reversal. As always, we will examine the potential effects on the financial and commodity markets from the North Korean threat.

The North Korean Problem

Although nominally Marxist, North Korea is probably best characterized as a hereditary monarchy. The current leader, Kim Jong-un, is the third generation of Kims to rule the country. The nation was formed after the Korean conflict in the 1950s, with the Korean Peninsula separated at the 38th parallel. U.N. forces, led by the U.S., and North Korean forces, supported by mainland China, settled on this demilitarized zone (DMZ) after three years of war.

Both China and the Soviet Union supported North Korea in its recovery from the conflict. Kim Il-sung, the first “king” of North Korea, was closely aligned with the Chinese after the latter saved his army from defeat during the Korean War. But the U.S.S.R. also assisted in North Korea’s recovery.

Into the 1980s, North Korea survived, supported by its sponsors. However, as China under Deng moved to a market-based economic system and the Soviet Union collapsed, North Korea found itself mostly on its own. Otherwise, it was surrounded by either hostile or indifferent nations. The new Russia was generally unconcerned about North Korea. China was busy with development. Japan and South Korea were both strongly opposed to the Hermit Kingdom. The overarching superpower, the United States, was generally expecting the North Korean government to implode without support from China and the U.S.S.R.

And yet, over 20 years since the fall of the Berlin Wall, the Kim dynasty remains in power. A combination of policies has ensured that the regime remains in place. It is probably best described by George Friedman of Stratfor as the “ferocious, weak and crazy” strategy. In detail:

Ferocious: North Korea is essentially a garrison state which has employed a “military-first” strategy since the 1960s. The country has the fifth largest standing military in the world and including reserves is the world’s largest. It is estimated that the combined force of North Korea’s military and reserves is 9.5 mm out of a population of 24.0 mm. By some estimates, North Korea spends a quarter of its GDP on the military. North Korea has mass artillery on its side of the DMZ; analysts believe this deployment could not only reach Seoul but severely damage the South Korean capital. The drive for nuclear weapons is a natural extension of this first leg of the policy.

Weak: Every time something happens in North Korea, a parade of analysts is seen in the media predicting that the regime will fail in short order. They cite the weak economy and persistent famine as part of the reason why the Kim government is on its last legs. In 1994, officials in the Clinton administration agreed to support the provision to build light water nuclear reactors in North Korea under the assumption that the country’s imminent collapse meant the U.S. would never have to deliver on its promises.1 By appearing weak, North Korea paradoxically protects itself. Why attack a well armed nation that is on the brink of collapse? In reality, like most authoritarian regimes, the Kims only need to satisfy selected groups. This “selectocracy,” which is mostly made of military leaders, receives preferential treatment in return for loyalty and support. The Kims have little regard for the masses that exist on the brink of destitution because they cannot threaten political stability. Of course, deep social control via internal security services ensures that opposition cannot rise. Thus, when outside observers see what appears to be economic collapse, they are really viewing an economic system designed to maintain the military and the Kims in power. Mass starvation is not a real threat to the government.

Crazy: The final leg of the stool is for the regime to appear psychologically unbalanced. The belligerent rhetoric, the occasional attacks against the South, the missile launches, etc. are all carefully crafted to give the appearance that the Kims are capable of anything. Thus, it is better not to provoke them lest they “go nuts” and lash out. In reality, the Kims have shown they intend to maintain the dynasty. They have no intention of committing suicide. Instead, by acting unbalanced they have a better chance of executing a form of blackmail.

For the most part, it appears the program has worked; North Korea’s situation was precarious after the fall of the Soviet Union and China’s decision to restructure its economy. The Kims have played a difficult situation with skill. Even though Kim Jong-un is very young and seemingly unprepared for his new role, the transition appears to be working fairly well. Although China has become North Korea’s most significant (and, for the most part, only) trading partner, the regime seems to be able to defy Chinese wishes. China clearly wants North Korea to remain a buffer state between it and South Korea (and U.S. troops). It would prefer North Korea not develop nuclear weapons; all nations in the nuclear “club” are better off if no other nations join, simply because having such weapons offers benefits to their owners. However, there isn’t much evidence to suggest that China would be willing to abandon North Korea over its nuclear policy. In fact, China may be much more concerned about the regime collapsing. Such an event would likely prompt streams of refugees into China, an expensive and messy proposition.

Has Anything Changed?

The recent missile launch and North Korea’s third nuclear test, along with aggressive comments from the regime, have increased concerns that something has changed. North Korea isn’t described as the “Hermit Kingdom” for nothing. The workings of the regime are opaque and so anything said about it are estimations at best. With a new leader in place, however, there is concern that the recent tests and threats of war may be signaling something new.

It should be noted that the aforementioned stance of “ferocious, weak and crazy” has worked for North Korea. For the past two decades, the country has received food aid and other support, mostly after doing something its neighbors didn’t like. Threats are effective.

In general, governments have considered three different plans to bring regime change to North Korea. The first is by military action. If this is going to occur, it will likely come from either the U.S. or China. The latter has no interest presently in seeing the regime overthrown. The U.S. would like to see the Kims go away but doesn’t want it bad enough to go to war. Clearly, if North Korea develops a modern nuclear weapon it will preclude any chance of military invasion. In the development of nuclear deployment practices since 1945, these weapons have become the ultimate defensive protection. No nation would seriously consider attacking a nuclear power because winning the war might trigger a nuclear response. Essentially, the advent of nuclear weapons has mostly eliminated the possibility of an unconditional surrender between such powers.

The second plan has been to placate North Korea. South Korea’s “Sunshine Policy” and the Clinton administration’s offer to build a light water reactor in return for ending North Korea’s nuclear weapons program simply enriched the regime. The Kims accepted South Korea’s largesse but used it to bolster the government, and they used the Clinton administration’s plan to continue work on a weapon and receive energy imports (the U.S. sent fuel oil to North Korea prior to building the reactors, which, of course, were never completed). Placating the regime doesn’t seem to work either.

The third option, seemingly being adopted by the Obama administration, is to simply ignore Pyongyang. So far, this seems to be fairly effective; however, it probably accounts for the recent escalation of activity and rhetoric. Like a three-year-old trying to get the attention of his parents, the louder and more obnoxious he acts, the greater the likelihood that he will get a reaction. However, as is often observed with parents, the reaction received is not what the child had hoped for. The risk of this option is that North Korea will escalate conditions and step over a “red line,” triggering an unwanted conflict.

The Future

It appears that North Korea and its new leader are probing the U.S. to see if it can generate a reaction and perhaps receive some assistance. So far, the Obama administration isn’t reacting much to the threats. Overall, the new leader’s actions are not much different than his predecessors.

We do expect that North Korea will continue working on nuclear weapons regardless of carrots or sticks. The primary goal of the regime is to remain in power. The Kims watched regimes in Libya and Iraq fall and correctly assume that if either had possessed nuclear weapons they would still be in power today. It is difficult to disagree with this assessment.

The problem for the U.S. and the world is that if North Korea does build a modern nuclear weapon (a warhead that can be attached to an intercontinental ballistic missile and survive reentry), then other nations in the neighborhood will as well. Japan and South Korea will likely want their own as well and further proliferation is likely. The problem with proliferation is twofold. First, the more nukes there are in the world, the greater the chances are that they will be used. Accidents occur. Second, it raises the possibility that non-state actors may acquire nuclear weapons and their behavior would not be as easy to predict as nation-state behavior has been. This isn’t to say that nation-state behavior has not been without risk. The U.S. and U.S.S.R. nearly came to a nuclear exchange on more than one occasion.


Despite all the recent rhetoric, it does not appear that anything has really changed in North Korea. The chances of a regime change are not high. No nation in the region has an interest in going to war over North Korea—it simply isn’t that important.

Unfortunately, if history is any guide, North Korea will continue to escalate conditions until its blackmail works. Ignoring North Korea’s antics does appear to be the most rational one in light of other aforementioned options, but not reacting to its behavior carries risks as well.

In general, if tensions escalate, we would expect South Korean and Japanese equity markets to weaken and their respective currencies to depreciate. Overall, unless North Korea engages in an act that triggers a significant military response, these dips should not last very long.

Bill O’Grady

March 25, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

1 Lind, Jennifer and Byman, Daniel, Pyongyang’s Survival Strategy: Tools of Authoritarian Control in North Korea, International Security, Summer, 2010,

Vol. 35, No.1.

© Confluence Investment Management

© Confluence Investment Management

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