North Korean Nuclear Threat Raises Odds of a South Korean Default
Financial markets are rattled Tuesday by increasing geopolitical risks, after North Korea warned it stands ready to deploy its nuclear arsenal if provoked by the United States. And the concerns reverberate throughout the region, affecting the communist nation’s democratic neighbor to the south as well.
The cost to insure against a sovereign debt default by South Korea suddenly jumped Tuesday, notes risk manager Larry McDonald on his blog, The Bear Traps Report.
It’s one of several market moves playing out Tuesday as investors increasingly flock to traditional safe-haven trades. U.S. Treasury yields have been falling for the last two days. Both gold and the Japanese yen climbed to their highest levels in five months on Tuesday.
Overnight, credit default swap spreads for South Korea jumped from 53 basis points to 60 basis points, meaning it would cost about $60,000 a year to insure $10 million of debt for five years. That’s the highest level since July, when concerns about economic weakness in Asia prevailed.
To be clear, the probability of a default by South Korea is still considered quite low, but nevertheless, the overnight jump is a dramatic one.
“South Korea is not going to default, but the probability of default just went from maybe 6% to 9%. It’s a big move to happen in short period of time,” McDonald told Fortune.
An obscure financial instrument that rose to greater prominence during the financial crisis, a credit default swap, or CDS, is basically an insurance contract against a default. Investors can buy a contract against a sovereign government like South Korea as they speculate on the creditworthiness of that government.
For U.S. companies with a large presence in Asia, these CDS contracts may be a useful hedge against geopolitical risk in the broader region.
“If I was the CEO of Apple, I would be buying credit default swaps on countries in Asia,” McDonald said. “If something were to happen politically in that region, your supply chain is at dramatic risk.”
Tweets by President Trump early Tuesday only added further fuel to the fire. The president tweeted that “North Korea is looking for trouble,” and reminded Chinese President Xi Jinping that China and the U.S. could strike a better trade deal if “they solve the North Korean problem.”
Those tweets follow Trump’s first face-to-face meeting with Xi Jinping just four days ago, which so far has led to no major breakthroughs or pacts between the world’s two largest economies.
“China didn’t give Trump everything he wanted in terms of assurances on their help with North Korea,” McDonald said. “If China doesn’t really offer enough support, that’s going to hurt the trade negotiations. That’s bad for Apple because you’ve got supply chain risk.”