WRAPUP 1-Japan, South Korea let currency swap lapse amid diplomatic row

* Deal on expanded swaps to expire end-Oct as scheduled

* Agreement comes amid diplomatic dispute over islands

* Seoul cites market stability, increased soundness

By Tetsushi Kajimoto and Choonsik Yoo

TOKYO/SEOUL, Oct 9 (Reuters) - Japan and South Korea willnot renew a $57 billion currency swap facility designed toprotect their economies against financial crisis, a decisionthey said was not related to a territorial dispute that has casta chill over ties between the neighbours.

Officials from both countries were quick to stress Tuesday's

decision not to extend the facility, set up last October asconcerns mounted about the U.S. budget deficit and Greece'spossible default, was made purely on economic grounds.

However, it may raise questions about the network ofbilateral swaps many Asian countries have set up if theagreements could be seen to come under pressure due to adiplomatic stand-off.

"It's not that the principle of separating economics frompolitics has been broken, but that this decision was made purelyon an economic point of view," South Korean Deputy FinanceMinister Choi Jong-ku said in Seoul.

"It is against principle to extend even when there is noneed."

The value of bilateral currency swap arrangements betweenthe two will return to $13 billion at the end of the month from$70 billion, South Korea's central bank said in a statement.

Markets showed little reaction. At 0600 GMT, the wonwas up 0.1 percent against the dollar, and the yen/won crossrate was quoted at 14.16 won compared with around14.18 late on Monday.

In contrast, when the deal was announced a year ago, it hadlifted the won to a one-month high against the dollar.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ FACTBOX: Korea's FX swap deals ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^> RISKS RECEDE

A political row broke out between Seoul and Tokyo in Augustafter South Korean President Lee Myung-bak visited islands thatboth countries claim sovereignty over.

Japan is also embroiled in a territorial dispute with Chinaover a different group of islands. Both rows are testing thelimits of Japan's economic cooperation with its neighbours.

"While there are political sensitivities surrounding theissue, it is the solid fundamentals of the Korean economy thathas most likely driven the decision," said Ronald Man, aneconomist at HSBC in Hong Kong.

"To some extent, the decision does reflect the relative easeof reopening the deal if necessary."

The expanded swaps were put in place last year as problemsin the United States and Europe had sparked fears of a repeat ofthe 2008 global financial crisis and 1997/98 Asian financialcrisis, with South Korea seen vulnerable to capital flight.

The risks of an exodus of capital have receded since theneven though the economic outlook remains uncertain, financialmarket volatility has fallen and South Korea's economicfundamentals have improved.

"Japan and South Korea reached a conclusion that extensionwould not be needed, while sharing a view that financial marketshave stabilised and macro economic situation has becomehealthy," Japanese Finance Minister Koriki Jojima said in Tokyo.

The remaining swap facilities could be expanded if needed,although there is no automatic right to access extra funds.

In a signal that economic links are still open, a Japanesefinance ministry official said on Tuesday the government wouldconsider purchasing South Korean government bonds from now on,although no decision had been made.

(Writing by Stanley White; Editing by John Mair)

((choonsik.yoo@thomsonreuters.com)(+822 3704 5580)(ReutersMessaging: choonsik.yoo.thomsonreuters.com@reuters.net))