Korean risk premiums exceed Thailand, ‘raised long term'

Tensions on the Korean peninsula mean CDS prices are likely to stay high for some time, analysts say

A rapid escalation in tensions followed announcements that North Korea was responsible for an attack on a South Korean naval vessel, which drew an instant response from the market. Spreads on South Korean sovereign five-year credit default swaps (CDSs) were pushed to a peak of close to 171.62 basis points on May 25, slightly higher than those of Thailand (170.375bp), which is also seeing political disturbance.

Economists at Standard Chartered say the dispute is causing an "economic rebalancing", with greater risk being priced into the market after the current jitters have settled. "Financial markets fell significantly... reflecting investors' concerns about a potential fundamental change on the Korean peninsula that may raise the risk premium in South Korea's financial markets," said Suk Tae Oh, regional head of research for Korea at Standard Chartered First Bank Korea in Seoul. Oh added that a full-scale military conflict was unlikely, though the stalemate between North and South would probably be "lengthy".

Economists at Nomura say the high CDS spreads on South Korean sovereigns reflects demand for hedging and risk aversion from foreign investors in the local equity and debt markets, as well as the large amount of Korean-issued foreign currency bonds outstanding. Concerns about European sovereigns have also highlighted the issue of sovereign risk, resulting in increased market volatility.

"If you look at the CDS then the volatility is definitely very high, but we're not getting the sense that there's a lot of volume going in, so it's probably more sentiment-driven, probably panicking just in case the tension escalates," says Yang Myung Hong, analyst at Nomura in Hong Kong.

Of the South Korea CDS peak, Hong says: "Those kind of levels suggested that there is going to be a significant risk event, but unless there is a substantial escalation or some kind of actual armed conflict, then these levels did seem quite wide. There definitely was an overreaction." Later in the week, the five-year CDS tightened to 129.8p at close on May 27. Hong notes that a good comparison to Korea for sovereign risk is typically Malaysia, which in normal times trades flat to Korea, but closed on May 27 at 102.47bp.

"I think if we don't have any more negative developments, even at the present levels we could probably see a little bit more tightening. But there still will obviously be a risk premium, so Korea may not drop back to levels in line with Malaysia in the near term," says Hong.

On May 20, an international joint military-civil investigation team announced the finding that the earlier sinking of the South Korean warship Cheonan was caused by a North Korean torpedo attack, something the North immediately denied. On May 24, the South Korean president announced a number of sanctions against the North, including suspension of economic exchanges.