Tensions on the Korean peninsula have substantially increased over the past couple of months with the not so Democratic People’s Republic of Korea (otherwise known as North Korea) testing several missiles and nuclear devices. North Korea has a strong interest to develop nuclear weapons as their leaders believe this armory will deter an attack from the U.S. (it is also used for domestic propaganda purposes). Under President Trump, however, this is not a given. At the UN General Assembly Mr. Trump threatened to “totally destroy” the country if it decides to continue developing nuclear weapons. For now, most commentators qualify the conflict as a war of words but, in our view, there is a real risk that this conflict escalates and could turn very ugly.

Whose missile is that…?

Clearly, every sane person would like to see the end of Kim Jong-un’s regime as well as the destruction of the country’s nuclear arms arsenal. Unfortunately, military action by delivering a “fire and fury” attack, as not so subtly promised by Mr. Trump, is risky as even with conventional weapons North Korea could make many victims by pointing its rockets towards Seoul. The Americans must have a lot of confidence in the effectiveness of THAAD, the defense system installed south of the border. In any case, onshoring heavy artillery, let alone (tactical) nuclear weapons, in South Korea to counter an attack from the North might unsettle China. An attempt to talk Mr. Kim into giving up its nuclear capability in return for, for example, economic assistance of some sort or diplomatic recognition may be futile. Firstly, because the Koreans still remember (or are being kindly reminded by their regime of) the devastation of the war in the early 1950s when whole cities were blown away by American might. Secondly, because Mr. Trump unveils the U.S. as being an unreliable party: he threatens to tear up the nuclear agreement with Iran even though, according to the IAEA, Iran is complying with the 2015 accord (our expectation, or hope, is that sensible people around Mr. Trump will talk him into signing a 90-day extension). His tweets full of war talk, obviously, don’t help. Thirdly, because every time since 1993 the Americans tried to negotiate a deal, the North Koreans cheated. A good thing is that the U.S. has China on its side as China agreed to impose sanctions on the belligerent country (North Korea, that is). China does not necessarily want to remove Mr. Kim from power but his actions have triggered the U.S. to take an unwelcome interest in China’s backyard. This is clearly not something China’s leaders cherish.

Is that missile mine…?

Mr. Kim and his cronies know that they are toast when they start a war (i.e. hitting Guam or any other place under Western influence), so it is not likely that they will resort to such measure other than by accident. We are not sure whether we can count on common sense of the U.S. in this matter. They may believe they can bomb the Koreans (the northern ones, we hope) into submission, possibly with disastrous consequences. And negotiating a Manhattan real estate deal is not exactly the same as dealing with a bellicose despot who possesses weapons of mass destruction. Trump already seems frustrated by lack of progress and might lean on his generals to strike.

In our view, China should step up to the plate and take the lead. They have most leverage over North Korea, being their only important trading partner. China has also most to lose from a political point of view, given they want to assert their role as the leading global power (think of roads and belts). China’s economy will be hurt most (apart from South Korea’s) if and when the conflict gets out of control and results in outright war. China’s leaders should ensure the sanctions bite and then offer to soften their stance if North Korea abandons its plans to develop nuclear weapons, of course, being monitored by independent experts (of the IAEA, for example). Risk of actual (nuclear) war is very small but the impact will be high. Given where South Korean corporate credits trade today (yields 3.2%, spreads 1.25%), we would lighten up, if not sell down to zero. Meanwhile, somebody should disable Twitter in North Korea…