&#91OUTLOOK&#93The crisis and Korea's economy

A few years back, I asked a South Korean minister of finance if he took North Korean behavior into account when formulating South Korean economic policy. "No," he replied, "those guys in the North are crazy. We don't pay any attention to them."

This insouciance still appears to be alive and well south of the 38th parallel: A recent survey of South Korean CEOs found that they were more concerned about the economic policy of the incoming South Korean government, the prospect of war in Iraq, and the possibility of a recession in the United States than the behavior of the Kim Jong-il regime.

Yet in certain respects, the situation today is different than it was in 1994, the last time there was a nuclear crisis on the Korean Peninsula, and the implications for the South Korean economy could be more profound this time around.

There are three contributing factors. Financially, South Korea is more integrated into the world economy now than it was in 1994. Residual restrictions still existed on outbound investment by households and firms, and inbound flows were highly controlled -- South Korean firms were restricted in borrowing abroad and foreign firms faced impediments in virtually every financial market segment. There were limits on foreign stock and bond purchases, and foreign banks, brokerages and other financial services firms had a negligible role in the South Korean market.

Today South Korean financial markets have been substantially liberalized. Foreigners are major players in the capital markets, accounting for nearly 40 percent of stock market transactions, and South Korean residents have greater opportunities to move their funds abroad. The use by South Korean financial firms of off-balance sheet transactions and financial derivatives, which did not exist in 1994, is expanding rapidly. While it is true that the South Korean stock market actually rose during the last crisis, the expanded role of non-Korean participants and the increased complexity of the financial transactions mean that the market today is far less susceptible to political intervention than it was a decade ago.

The popular image of capital flight occurring when foreigners head for the exits is belied by historical experience the world over: Almost invariably, it is the better-informed local folk who are out the door first. Indeed, the latest figures indicate that while foreigners have been net buyers in the stock market, Koreans were net sellers. And although at present there is no indication of capital flight, enabling mechanisms that did not exist in 1994 are in place today, and if December's election is any indication, the South Korean population is badly split with respect to its attitude toward the North. South Korean investors may prove more risk-averse than their new government and move their savings abroad. A slowdown in the purchase of consumer durables is another possibility.

Indeed, the incoming government -- populist and untested -- is another source of uncertainty. The incoming administration faces three main economic challenges: strengthening the bankruptcy/insolvency resolution system, improving transparency and corporate governance, and continuing the process of privatization and denationalization, especially in the banking system. President-elect Roh's attitudes and actions with respect to labor market issues will be scrutinized.

While Mr. Roh has largely managed to avoid economic controversy in the run-up to his inauguration, the markets will monitor his government's economic policies particularly closely during the early stages of his administration. Moreover, even if President Roh, as expected, places a greater emphasis on political reform over economic reform at the start of his administration, South Korea's financial integration with world markets and external events may constrain his ability to establish political priorities according to his own agenda. The march of events, not Mr. Roh's political desires, may frame that agenda. In South Korea there may be more anti-American demonstrations, and in the United States there may be more calls to remove U.S. troops from the soil of an apparently ungrateful ally. While these events are more likely to be annoying than debilitating, they will be an ongoing political distraction.

Which brings us back to North Korea. Given the complexity of the situation -- two separate and distinct nuclear programs that require different solutions, the administrative transition in South Korea, and the looming war in Iraq -- a resolution of the crisis is likely to be protracted and will almost certainly involve multilateral negotiations, if not the UN Security Council. As a consequence, the crisis is likely to drag on for months, punctuated by intermittent periods of heightened tensions. As a result, South Korea is likely to experience an extended period of market sensitivity -- even if South Korean businessmen and economic policymakers are comfortable ignoring the wild and crazy guys up north.

* The writer is a senior fellow at the Institute for International Economics in Washington D.C.

by Marcus Noland