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By Jeremy Laurence
SEOUL, Nov 24 (Reuters) - China on Wednesday came under heavy pressure to tame its ally North Korea after the reclusive state attacked South Korea, with the United States trying to cool tension in the economically powerful region.
Tuesday's artillery attack on a South Korean island killed two soldiers, sent scores of civilians fleeing and sparked a sell off in stock futures and the won in offshore trading. Futures for stocks and bonds have since recovered.
WHAT WILL HAPPEN NEXT?
Tuesday's barrage was the heaviest bombardment on the South since the Korean War ended in 1953. Tensions are running high in the region. But it is extremely unlikely that this marks the start of an escalating conflict that could lead to a major military confrontation between the two Koreas.
For decades, North Korea has followed a strategy of trying to wring concessions from the international community through periodic provocations, carefully calibrated to raise geopolitical tensions without sparking full scale war.
Provocations over the past few years include two nuclear tests, several missile tests, and the sinking of a South Korean warship in March which killed 46 sailors.
This latest attack is likely to be in line with this strategy. Rather than heralding further aggressive gestures in coming days that raise the geopolitical temperature, it is likely to be followed by a period of relative calm, or even overtures from Pyongyang for more peace talks.
North Korea has no appetite for a major conflict. The South Korean and U.S. militaries are far better equipped than the North's decrepit army which barely has enough fuel to fly its ageing fleet of fighter planes.
South Korean President Lee Myung-bak has vowed a firm response, but Seoul too has no desire for a serious conflict. While North Korea would certainly lose any war, it would be able to do enormous damage to the South with its vast artillery.
South Korea's reaction has been very restrained, just as it was in the aftermath of the sinking of the Cheonan.
WHY NOW?
There are several possible reasons why North Korea's military may have launched Tuesday's artillery barrage.
South Korea was holding military drills in the area, and has conceded that it was conducting test-firing exercises. This might have led the North Korean military to genuinely believe it was under attack, and to fire in retaliation.
Pyongyang regards South Korean military exercises with genuine unease, fearing the manoeuvres could be a smokescreen for a real attack. In recent years it has reacted with fury to South Korean drills, particularly when the U.S. military was also involved.
Events of the last week suggest North Korea is again trying to provoke the international community into making concessions. It has unveiled major advances with its uranium enrichment programme, giving it a second route to make a nuclear bomb.
Pyongyang's decision to show off its technological advances to Western scientists, coupled with Tuesday's attack, may be a strategy aimed at scaring the South and its allies into easing sanctions or restarting peace and disarmament talks.
A final factor that may have played a part in the timing of the incident is that the North has entered a period of leadership transition.
At a major ruling party meeting in September, Kim Jong-il appointed his youngest son to key posts, a move seen as formally anointing him as North Korea's next leader. Kim is widely thought to be in failing health after suffering a stroke in 2008, and this may have led him to speed up succession plans.
But his son, Kim Jong-un, is young and has no real support base, and there is always the risk that powerful figures in the military or government decide this is an opportune moment for a power grab.
The North's economy is going from bad to worse, another factor that may fuel internal instability and discontent.
Tuesday's incident and the Cheonan attack in March may have been attempts to bolster unity among North Korea's elites by focusing attention on an external enemy, or a bid to bolster Kim Jong-un's credentials in the military.
Or they may have been launched by hawkish elements of the military without the knowledge and support of Kim Jong-il.
"With the ongoing leadership transition in North Korea, there have been rumors of discontent within the military, and the current actions may reflect miscommunications or worse within the North's command-and-control structure, or disagreements within the North Korean leadership," geopolitical risk analysis firm Stratfor said in a comment on Tuesday.
HOW HAVE MARKETS REACTED?
Asian shares fell on Wednesday and the euro hovered near a two-month low to the U.S. dollar as regional stocks caught up with a sharp sell-off after the shelling, and investors sought safety in the U.S. currency.
South Korean stock and bond futures, however, rose on Wednesday as foreign investors looked for bargains in local assets after the artillery attack on the South led to a panicked sell off on Tuesday.
The won was down around 0.7 percent and shares in both South Korea and neighboring Japan, whose markets were closed on Tuesday, were underperforming the region, reflecting the seriousness of the attacks.
The main KOSPI stock index, which closed right before the brunt of Tuesday's selloff, was down 0.7 percent but off its early lows. Food-related stocks and shares of companies that make military equipment were outperforming.
Turnover in the main market with more than three hours to go before the close was 4.7 trillion won, nearly three quarters of the daily average turnover for last month of 6.5 trillion won.
The cheapness of Korea's equities, tough and highly competitive industries and the country's current account surplus were draws for foreign and domestic institutional investors, analysts said. Even the diminished threat of capital controls, an unforeseen byproduct of the shelling, was cited by analysts as a reason to buy back Korean assets.
In credit markets, Korean bonds were trading higher, and the 5-year sovereign credit default swaps, basically insurance against default, were at 97/99 basis points compared with Tuesday's widest levels of 107 reached during the New York trading session.
South Korean asset markets have grown used to Pyongyang's provocations. They tend to suffer only a brief and modest dip in response to North Korean sabre-rattling, as a few players engage in knee-jerk selling, but prices tend to recover quickly.
Todd Martin, Asia equity strategist with Societe Generale in Hong Kong, said Korea was his pick for second-best performing market next year in Asia next to Japan.
However, given heightened sensitivity to risk in global markets, the potential for a sharper sell-off cannot be discounted. In April, when Seoul formally blamed the North for the Cheonan attack, panicky investors dumped South Korean assets.
Still, since Tuesday's attack is highly unlikely to escalate into a more serious confrontation, market reaction in coming days will probably be on the upside.
WHAT ARE THE RISKS TO THIS PICTURE?
The biggest risk is that North Korea's leadership transition and economic problems result in the leadership making risky moves that go beyond the provocations of the past and cause events to spiral out of control.
With Kim's health uncertain, his son still an unknown quantity, the delicate balance that has kept the peninsula tense but peaceful for decades may be unravelling. While neither side wants war, there is always the risk that misunderstandings or miscalculations lead to unintended conflict.
The other main risk to South Korea is what happens when North Korea's regime eventually collapses. That prospect is regarded with dread by many regional policymakers because of the enormous economic costs a sudden chaotic reunification of the two Koreas would impose on the region.
"Any additional risk premium that the market imposes in KRW assets is likely to be embedded more in longer-term yields, which should support a steepening of the IRS curve in spot and forward terms," Nomura said.
(Additional reporting by Chris Buckley in Beijing and Andrew Marshall in Singapore; Editing by Miral Fahmy)