South Korea: Look North … and West

by Ivan Martchev | April 5, 2013 7:00 am

South Korea: Look North … and West

It is a rare opportunity for one to be able to put Dennis Rodman, Eric Schmidt and Kim Jong-un in the same sentence, but it has now presented itself with several private diplomacy shuttles targeting the DPRK in the past three months.

The desire to bring North Korea out of isolation is commendable, even though probably futile for the time being, given the recent “war” rhetoric from Pyongyang.

The most relevant historic parallel that can be drawn is between East and West Germany, where the reunification full circle took 45 years after the end of World War II. This time it has been 60 years and counting after the armistice that ended the Korean War, yet progress toward reunification is elusive.

To make a point regarding the backward nature of the separated communist North, former Defense Secretary Donald Rumsfeld pointed to one of his favorite pictures — that of the North and South at night[1] — showing the massive divergence in development that has occurred since the end of the Korean War.

But how does the recent war rhetoric from Pyongyang affect investors in the region?

Previously, during elevated tensions with the North, the South Korean won (KRW) has tended to weaken[2], with selloffs in both the bond and stock markets. Most times the declines are small, given that the situation has never really gotten out of hand, even with the sinking of South Korea’s Cheonan vessel in 2010[3] by a North Korean midget submarine.

Naturally, if this time the situation escalates past midget submarines, the selloff might be bigger, but this is impossible to predict given the benign outcome of all such similar skirmishes over the past 60 years.

Should this conflict with the North blow over, South Korea’s economy will be affected more by China, as it is by far its largest trading partner — 24.2% of Korean exports go to China, while 16.5% of its imports come from there. A decade or so ago, the U.S. used to hold that most important trading partner position, yet the rapid growth of the Chinese economy has quickly given it regional hegemony.

While the overall Chinese current account surplus has shrunk from 10.1% of GDP in 2007 to 2.3% of GDP in 2012 as the Chinese economy has doubled, the move toward a more “normal” balance is deceptive. China still runs its own trade surpluses with many developed markets (save for Australia[4], which is its main source for commodities), but it seems to have chosen to run trade deficits with many Asian countries like South Korea to increase its regional influence.

As one would expect, this close economic entanglement has caused the iShares MSCI South Korea Capped ETF (NYSE:EWY[5]) to have close correlation with Chinese equities[6] as represented by the iShares FTSE China Large-Cap ETF (NYSE:FXI[7]). Interestingly, neither the FXI (that represents H shares of mainland companies listed in Hong Kong) nor the EWY ETFs have strong correlation to mainland-listed A shares[8]. This suggests that sooner or later, the Chinese capital markets need to open and the Chinese yuan needs to float freely for the capitalist economic system — clearly chosen by the Chinese government — to begin allocating capital more efficiently.

The iShares MSCI South Korea Capped ETF is one of the more efficient ways to gain exposure to the No. 1 smartphone maker Samsung (PINK:SSNLF[9]), which has no ADRs and just a thinly traded pink sheet listing, despite being the largest holding in the MSCI Emerging Markets Index. (The MSCI Emerging Markets Index is as important to investors interested in emerging markets as the S&P 500 is to investors interested in U.S. stocks).

In addition to EWY, there are 11 ADRs to choose from.

One is Korea Electric Power (NYSE:KEP[10]), which has not been paying dividends since 2008. Utility stocks globally are typically income stocks and are near all-time highs, but not in this case. Since oil, natural gas and coal are imported to South Korea, record input prices caused large losses for KEP, hence the dividend cut. It is impossible to say when KEP will re-institute a dividend, but the company is integral to South Korea’s development, and the shares have not participated in the rally in the local benchmark index, trading at 0.38 times book value.

This might be a patient turnaround story, but it is typical that economic growth leads to faster electricity growth, so in this case, things are likely to change for the better. Plus, one day, KEP might “turn the lights on” in North Korea, which makes it a unique infrastructure play … regrettably at a time impossible to estimate at present.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates hold positions in Korea Electric Power for some of its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser before making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

Endnotes:
  1. that of the North and South at night: http://www.google.com/imgres?imgurl=http://www.globalsecurity.org/wmd/world/dprk/images/dprk-dmsp-dark-old.jpg&imgrefurl=http://www.globalsecurity.org/military/world/dprk/dprk-dark.htm&h=722&w=974&sz=119&tbnid=X6jHCUNCmXhDmM:&tbnh=90&tbnw=122&zoom=1&usg=__mV1lOkvacadKAIZfWRkQ7zwMEyU=&docid=mV1EzqMWCRx2mM&sa=X&ei=JRNJUcfDNefi4APw-IC4Cg&ved=0CEEQ9QEwBA&dur=115
  2. the South Korean won (KRW) has tended to weaken: http://www.bloomberg.com/quote/USDKRW:CUR/chart
  3. sinking of South Korea’s Cheonan vessel in 2010: http://en.wikipedia.org/wiki/ROKS_Cheonan_sinking
  4. Australia: http://investorplace.com/2012/06/why-they-should-learn-mandarin-in-australia/
  5. EWY: http://studio-5.financialcontent.com/investplace/quote?Symbol=EWY
  6. close correlation with Chinese equities: http://stockcharts.com/h-sc/ui?s=FXI&p=D&yr=3&mn=0&dy=0&id=p79424060191
  7. FXI: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXI
  8. mainland-listed A shares: http://stockcharts.com/h-sc/ui?s=$SSEC&p=D&yr=3&mn=0&dy=0&id=p84952160345
  9. SSNLF: http://studio-5.financialcontent.com/investplace/quote?Symbol=SSNLF
  10. KEP: http://studio-5.financialcontent.com/investplace/quote?Symbol=KEP

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