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A united Korea: the investment perspective

As unlikely as it seems, and despite the recent isolationist rhetoric of North Korea’s Kim Jong-un, the 2018 Winter Olympics could witness the first steps towards the reunification of the Korean peninsula. Rivalled only by the coming together of East and West Germany in the 1990s, reunification would be a historic political event.

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As unlikely as it seems, and despite the recent isolationist rhetoric of North Korea’s Kim Jong-un, the 2018 Winter Olympics could witness the first steps towards the reunification of the Korean peninsula. Rivalled only by the coming together of East and West Germany in the 1990s, reunification would be a historic political event. But would it be good news for investors? Ben Surtees, fund manager on Jupiter’s Emerging Markets team, argues that while reunification would be extremely challenging in the short term, if Korea can withstand the short-term hardship, the long-term benefits could make the pain more than bearable.

Ignore the noise

Following a period in which North Korea has antagonised much of the West with a series of threatening missile tests, the decision by the two Koreas to field a joint team at this year’s Winter Olympics had Korea “watchers” divided over the importance of the move. Was it a first baby step towards the reunification of the two Koreas, or a cynical ploy by North Korea to gain more bargaining power as it seeks to get sanctions lifted against the country? All this political noise is nothing new for investors in South Korea who have had to withstand corruption, international sanctions and the threat of war on an almost continuous basis since the end of official hostilities with the North in 1953. Just last year, President Park Geun-hye was impeached and imprisoned for corruption following weekly protest rallies, China banned some of its citizens from visiting South Korea in reaction to the government’s decision to install a US missile defence system, and North Korea successfully created and tested a hydrogen bomb. Unsurprisingly, many investors ran for the hills. The Kospsi index, however, still proved to be one of the better performing in Asia, with one year returns of 20% - over 30% when combined with the strength of the currency.

Starting from a discount

Bearing in mind its strong performance in 2017, it is worth noting that this is a market that continues to trade at a discount to its Asian peer group. South Korea’s benchmark index trades at a lower price-earnings multiple than most comparable emerging markets, and this gap has continued to widen. It is now recognised to be at a discount regarded as an attractive entry point. Ironically, this comes at a time when the earnings growth of KOSPI is forecast to be one of the highest in the region.

Of course, the North Korean threat is a major contributor to this discount, but even this is outweighed by South Korea’s poor governance record. South Korean companies are plagued, in our view, by boards lacking independence and more questionable business ethics, highlighted by the fact that the dividend pay-out ratio of South Korean companies is at almost half the level of anywhere else in Asia.

However, this discount is not necessarily structural, and the tide could very well be turning. The introduction of a liberal Government has seen the introduction of a stewardship code. A similar code has been introduced in Japan and had a positive impact on the Japanese market, boosting the valuations of Japanese companies that chose to embrace better standards of governance and adopt capital management initiatives that better align the owners to minorities. Like in Japan, I’m confident the code will also force many Korean companies to relinquish their poor governance practices, which should help to improve valuations.

Economic fallout of reunification

The importance of better governanceis , however, overshadowed by the question of a hypothetical reunification of the two Koreas and the impact such a move would have on South Korea’s thriving economy.

Looking to historical comparisons, the only true like-for-like example we have is the reunification of East and West Germany in the 1990s. As is now the case with the Koreas, there was at the time a significant disparity in income, and West Germany, the wealthier partner, was presented with two options. It could either have used state handouts, subsidies and investments to narrow the gap in inequality between East and West, or allow a mass wave of migration from East to West. They chose the first option and are still paying for it 25 years later.

Unfortunately, this would likely be an even larger problem for South Korea. North Korea is considerably bigger than East Germany, home to roughly 25 million people. Alongside that, the income disparity between North and South Korea is even more significant. The average income per person in North Korea is roughly just under 5% of the average South Korean income . This means that for South Korea, reunification could simply mean replacing the threat of war with the threat of economic peril.

A potentially appealing outlook

But there could be long-term benefits. North Korea possesses numerous mineral deposits, including coal, that have provided some energy independence. They also have a large pool of cheap labour keen to work, which domestic South Korean companies would be able to draw on. Not only that, reunification would remove the threat of war, which should reduce the defence budget as well as the psychological impact on those affected by the constant threat.

An open Korea could mean trade routes opening up from Seoul to Beijing, and then on through to Moscow and the Middle East. All these new routes would reduce the reliance on trade with the US and Japan, whilst allowing the country to better promote its exports in markets in which it has traditionally struggled, such as China.

Ultimately, the short-term consequences would be an extremely bitter pill to swallow for South Koreans and investors alike. But in much the same way that Germany now dominates Europe, Korea could – and this is a strong could – occupy a similar position in Asia in the future. A potentially appealing outlook for a market that still remains deeply discounted.

Ben Surtees , February 26

Article also available in : English EN | français FR

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