The Korea-US joint military exercise, Ulchi-Freedom Guardian, has begun. As the military drill takes place, the geopolitical risks surrounding the Korean Peninsula are again in the spotlight. Heightened tensions had just started to subside with the US and North Korea both taking a step back from their hardline stance. However, with the annual military drill starting this week, there are risks of additional provocations by the North. North Korea-related risks have always been a threat to the Korean economy. We will take a closer look at these threats and countermeasures with IBK Economic Research Institute’s Vice Director Cho Bong-hyun. Let’s first take a look at the market’s reaction in regard to the North Korea risks.

The Korea-US Ulchi-Freedom Guardian exercise takes place from August 21. There are fears the joint military drill will lead to North Korean provocations. North Korea carried out another flight test for its intercontinental ballistic missiles (ICBM) on July 28, further escalating tension on the Korean Peninsula. The escalated tension has caused confusion in the Korean financial market and economy, with the won to dollar foreign exchange rate going up by around 20 won in the 11 days following the missile launch. The credit default swap premium also rose 10 points since the launch, recording the highest level so far this year. Korea’s stock market was even more shaken up with foreign net selling reaching 1.864 trillion won after the launch. As time has passed, the jittery financial situation has calmed a bit, but there is still a lot of anxiety in the market. That is why analysts predict that foreign investors will be responding sensitively to changes in the Korean financial market, especially with increased tensions due to the joint military drill.

The Korean market has been jittery since North Korea successfully launched an intercontinental ballistic missile on July 28. Since US President Donald Trump warned of “fire and fury” against North Korea on August 8, over 1.47 trillion dollars flooded out of the stock markets worldwide in just three days. Korea, standing at the center of the risk, lost 77.5 trillion won during the same time. Korea’s credit risk has also increased due to risks stemming from North Korea. According to the Korea Center for International Finance, Korea’s credit default swap (CDS) reached 70 basis points, recording its highest level since February 25, 2016. However, as heightened tensions subsided between North Korea and the US, Korea’s benchmark KOSPI recovered to the 2,350 range on August 16, and the won to dollar exchange rate is slowly recovering as well. Nonetheless, it is too early to talk of a full recovery.

There has always been a lot of risk with North Korea’s nuclear tests or missile launches. The Korean economy’s foundation is strong and it has learned through North Korea’s continuous provocations. That is why market jitters have soon subsided. However, what is different this time is that the North Korean risk itself is unstable and it is expected to be protracted. There are many reasons for this but North Korea has continued provocations with successive ICBM test launches and there are even signs of a sixth nuclear test. The US has also responded with a hardline stance to these provocations, increasing conflict between the two sides and leading many to believe that the situation on the Korean Peninsula cannot be resolved quickly. This has been reflected in the Korean economy and market.

In the past, North Korea risks subsided fairly quickly, sometimes within a week or a month. But the situation this time around is different. The Ulchi-Freedom Guardian military exercise is likely to provoke the North as North Korea and China have called for Korea and the US to either halt or reduce the scale of the drills each year. In addition, the US has upped the ante on its response to North Korea’s provocations and nuclear test, which is why the risks stemming from North Korea are expected to be prolonged.

Currently, the conflict between North Korea and the US has subsided a bit, but the risk is still there. If this sort of situation continues, Washington carrying out a preemptive strike against Pyongyang might become a reality and this would deal a big blow to the Korean economy. The economy is showing signs of picking up, but if tensions on the Korean Peninsula increase it could put a damper on the recovery trend. Some analysts say Korea’s growth rate could drop by as much as 1.1 percentage points, while the won to dollar exchange rate could reach 1,180 won against the dollar due to the situation.

The Korean economy has been doing very well lately, growing 2.3% in November last year compared to the same period in 2015. Exports have picked up, showing nine consecutive months of growth. Facilities investment and consumer spending has also been showing signs of improvement. Korea’s economic growth rate forecast has also been revised up to 3% from last December’s 2.6%. However, if North Korea risks become prolonged, Korea’s growth rate forecast will be threatened. As consumption and investment contract due to worsening economic sentiment, it could lead to a drop in the economic growth forecast, while the impact on the financial and foreign exchange markets could become a factor leading to global unrest. In order to avoid such a situation, the government is acting fast.

Compared to previous administrations the current government is closely watching the situation and preparing for contingencies. Especially since the Moon Jae-in government took office, we’ve been seeing positive signs in the economy. However, North Korea’s provocations could put a damper on the current recovery trends, which is why the Moon administration is paying extra care to prepare thoroughly for the situation. Just last week, the finance minister and Bank of Korea governor held talks to address pressing issues affecting the economy and promised to take decisive actions to stabilize the market. Economic policymakers are trying to establish measures to buffer the shock that North Korea-related risks bring to our economy and financial market, so that the current recovery trends that we’ve been seeing can continue.

The nation’s top economic policymakers, finance minister Kim Dong-yeon and BOK governor Lee Ju-yeol, met on August 16 to address pressing issues affecting the local economy. After the discussions, the two decided to take tough action if needed against risks to the economy posed by North Korea’s nuclear and missile threats. With this message, the benchmark KOSPI rose 0.6% from the previous day, closing at 2,348.26. However, as concerns over geopolitical risks remain, further countermeasures will be needed in the future.

Of course, our economy has the strength to withstand risks stemming from North Korea but foreign investors have the tendency to put too much meaning into the situation on the Korean Peninsula. We need to inform related countries and investors that the Korean economy has the strength to withstand geopolitical risks and put in active efforts to contain the risk. Also, in the case that North Korean risks escalate, our companies and economic entities must thoroughly prepare for the case that North Korean risks do arise. Of course, mitigating risk is important, but the Moon administration’s blueprint for a new economic map of the Korean Peninsula which calls for the North’s economic revival and the South’s new leap forward is a grand plan that could possibly help create a stable economic environment on the Korean Peninsula.

If North Korean risks continue to rise, crises will become a routine occurrence. As such, the government must keep all possibilities open and prepare preemptive countermeasures in order to peacefully resolve the unstable situation on the Korean Peninsula.