Does Nuclear Uncertainty Threaten Financial Markets? The Attention Paid to North Korean Nuclear Threats and Its Impact on South Korea's Financial Markets

• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/asej.12142
• Date: 01 March 2018
• Author: Ju Hyun Pyun,In Huh

Does Nuclear Uncertainty Threaten Financial

Markets? The Attention Paid to North Korean

Nuclear Threats and Its Impact on South Korea’s

Financial Markets*

In Huh and Ju Hyun Pyun

Received 27 December 2016; Accepted 27 December 2017

We explore how investor attention paid to dangerous nuclear tests influences

financial market outcomes. To measure the attention paid to North Korean nuclear

threats, we introduce a weekly Google search volume index for keywords on

North Korean nuclear events. Using a time-varying structural vector autoregres-

sion model with block exogeneity restrictions, we find that investor attention paid

to nuclear threats has heterogeneous effects on South Korea’s stock prices across

industries and over time: attention on only the first nuclear test was negatively

related to the stock price index, which vanished thereafter. Moreover, the investor

attention paid to the nuclear risk reduced stock prices, especially in the banking

industry, during the entire sample period.

Keywords: block exogeneity, Google search volume index, investor attention,

North Korean nuclear risk, political risk, structural vector autoregression model.

JEL classification codes: F30, F50, G10.

doi: 10.1111/asej.12142

I. Introduction

North Korea has been regularly provoking South Korea since the Korean Armi-

stice Agreement was signed in 1953. As recently as the 2000s, North Korea

conducted several prominent military actions, including the Yellow Sea battle,

attacks on the Cheonan ship and Yeonpyeong Island, and various missile

launches, which can only be construed as grave threats to South Korea. North

Korea also started conducting nuclear tests in 2006, which have been heavily

*

Huh: The Catholic University of Korea, Department of Economics, 43 Jibong-ro, Wonmi-gu,

Bucheon-si, Gyeonggi-do 14662, Korea. Pyun (corresponding author): Korea University Business

School, 145 Anam-Ro, Seoungbuk-Gu, Seoul 02841, Korea. Email: jhpyun@korea.ac.kr. We are

grateful to Boyoung Choi, Minsoo Han, Zonglai Kou, Abul Shamsuddin, Haizhi Wang, an anony-

mous referee, and participants at the 9th Annual Conference between Chonnam National University

and Fudan University, China, the KIEP seminar, Korea, the 7th IFABS conference, China and the

2016 WEAI meeting for their helpful comments. This work was supported by the Catholic Univer-

sity of Korea, Research Fund 2015. All remaining errors are our own.

© 2018 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2018, Vol.32 No. 1, 55–82 55

criticized and have intensified the political and geographical uncertainty in the

Korean peninsula. North Korea’s ambition to be a nuclear state has not only

raised concerns about a potential war between North Korea and South Korea but

also puts world peace in peril. There are various views on North Korea’s nuclear

tests, as noted in the New York Times in April 2013: ‘Many analysts believe that

North Korea is again seeking aid and other concessions, while some suggest that

it merely wants to be recognized as a nuclear state, like Pakistan. Still others

suggest that the North genuinely fears an attack by the USA or South Korea and

views the warnings as deterrence. Highlighting a perceived threat from abroad is

also a favorite tool the North Korean government uses to ensure internal cohe-

sion’(Choe et al., 2013). It is difficult to identify North Korea’s true intentions

behind the provocations and threats (i.e. whether or not the threats are empty);

thus, it is a challenge to identify the ‘real’effect of such risks on South Korea’s

financial markets.

The present study analyzes how North Korea’s nuclear risk influences South

Korean financial markets from an investor’s viewpoint. We provide a new way

to measure investor attention paid to North Korean nuclear threats in the form

of a Google search volume index (SVI) that measures the online search fre-

quency of related keywords pertaining to North Korea’s nuclear events

(Da et al., 2011). This measurement helps to quantify an investor’s demand for

information on North Korea’s nuclear threats and provocations. Using weekly

data for 2004–2012, we employ a structural vector autoregression (VAR) model

with block exogeneity restrictions by treating the attention paid to the nuclear

threats as a given exogenous variable and considering endogeneity among finan-

cial market variables.

We find that the attention the market paid to very early North Korean nuclear

threats was negatively related to the South Korean stock market price index

(KOSPI); this negative effect on the stock prices of the attention paid to the

nuclear threats attenuated afterward. Interestingly, the attention paid to the sec-

ond nuclear test was significantly associated with depreciation of the Korean

won. Furthermore, we investigate heterogeneous responses of industry-specific

stock prices to the nuclear risk. Our results show that only the banking industry

was considerably hit by the nuclear risk in terms of industr y stock price; stock

prices of other industries did not respond significantly. We show that our results

are robust by controlling for alternative measures, specifications and

identification.

Many previous studies show significant financial market reactions (price

changes and volatility) to exogenous political conflicts or social crises. Frey and

Kucher (2000) and Waldenstrom and Frey (2002) examine the impacts of events

during World War II on the prices of several countries’government bonds

traded in Sweden and Zurich (Switzerland), respectively. Amihud and Wohl

(2004) and Rigobon and Sack (2005) focus on the Iraq War and its conse-

quences for financial markets. Amihud and Wohl (2004) find that Saddam Hus-

sein’s fall from power, as reflected in a traded futures contract that paid out if

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