A giant offshore crane salvages the bow section of the South Korean naval ship Cheonan off Baengnyeong Island shortly after the sinking
North Korea says the peninsula is heading toward war, after Seoul accused the reclusive state of torpedoing a navy ship near their disputed border, driving tensions to their highest levels in years.
Sovereign 5-year credit default swap spreads hit a spread of about 145, their highest in eight months.
Following is a summary of key South Korea risks to watch:
* THE NORTH Tensions with the North have ratcheted up the risk level across north Asia, which accounts for one-sixth of the global economy. The greatest risk would be war. North Korea could lob thousands of artillery rounds into the Seoul region, home to about half South Korea's population, and fire missiles at cities in South Korea and Japan, causing crippling economic damage.
Analysts believe war to be unlikely. North Korea's obsolete conventional armed forces and military equipment mean quick and near certain defeat if it wages full-scale war, and Pyongyang is well aware of its limits. Even though it has exploded nuclear devices, North Korea has not shown it has a working nuclear bomb. Experts say they do not believe the North has the ability to miniaturize an atomic weapon to place on a missile.
Moreover, South Korea has made clear it will not retaliate after findings showed it was a torpedo fired by a North Korean submarine that sunk the Cheonan corvette, killing 46 sailors.
The greatest risk that could fuel armed confrontation lies in small-scale skirmishes that might develop into larger conflict. Another risk could be a buildup of U.S. forces that will be seen by the North as a sign of imminent invasion, something leaders in Pyongyang are said to be genuinely afraid of.
Besides war, another risk scenario for markets would be the implosion of the North Korean regime, leading to sudden reunification. Most estimates say it could cost Seoul more than $1 trillion to absorb its impoverished neighbor.
What to watch:
-- The rhetoric on both sides. Most skirmishes and North Korean missile tests tend to have only a fleeting impact on markets accustomed to Pyongyang's saber-rattling. But South Korean stocks took a dip and the won posted its biggest daily fall in more than 10 months following the South's formal announcement of blame for the ship sinking. Hawkish comments from both sides weighed on investor sentiment, already fragile after lingering concerns over euro zone debt problems.
-- Clues on the stability of the North Korean regime. South Korean assets would dive if it seemed the North was imploding and reunification was likely. Some analysts see the torpedo attack as a sign of desperation. The North's decision to revalue its currency in late 2009 sparked rare internal protests. Leader Kim Jong-il risks instability as he pushes through new economic measures to reassert control over the economy.
* GOVERNMENT EFFECTIVENESS AND ECONOMIC REFORM
After suffering a collapse in popularity upon taking office just over two years ago, President Lee Myung-bak has seen a surge in his support as South Korea's economy appears to be emerging from the global downturn more quickly than other major economies.
Lee's plan for job creation and his business-friendly reform agenda look set for delays in a parliament where infighting in his ruling, conservative Grand National Party and spirited opposition protests have postponed almost all of his plans. A parliament described by local media as dysfunctional has stymied many of the economic reforms proposed by Lee to make Asia's fourth-largest economy more competitive and open to investment.
What to watch:
-- Legislative delays. Parliament has achieved little this year other than debate a scheme to move parts of the capital out of Seoul and a government plan to revitalize the country's four major rivers. This pushed back Lee's proposed economic reforms that include tax cuts and a trade deal with the United States. This means fewer reforms will be passed and those that are will be approved later rather than sooner.
-- Labor laws and policies. A key indicator of Lee's political clout can be seen in his ability to push through his plans on job creation and adding greater flexibility into what is regarded as a rigid labor market.
* JUNE ELECTIONS
Elections will be held on June 2 for local offices including mayors of the largest cities. The vote is a test for Lee's policies and a measure of popularity for those seeking the presidency when his 5-year term expires in early 2013.
What to watch:
-- Political rifts in Lee's ruling Grand National Party. These will likely widen ahead of the election as presidential aspirants jockey for power. This may impact reform plans.
-- A spirited opposition. The left-leaning opposition will use the elections as a rallying point and try to show their strength by blocking any plans proposed by the government.
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