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A North Korea conflict will be 'credit negative' for South Korea

For decades, South Korea's economy and financial markets have shrugged off North Korea's periodic saber-rattling. But as Washington and Pyongyang persistently belt out aggressive rhetoric, the increased probability of conflict will be credit negative for Seoul, according to Moody's Investors Service.

Asia's fourth-largest economy currently has an 'AA2' rating under Moody's but that assessment could change if escalating politics result in an economic impact that the government can't respond to, said Marie Diron, associate managing director at the agency's sovereign risk group.

"What makes it different this time is the broadening nature of geopolitical risk," she told CNBC. "We're going from a period where we saw a potential fall of the regime in the North as a tail-risk to the rising probability of war on the Peninsula."

This week, North Korea accused President Donald Trump's administration of pushing the region "closer to the brink of nuclear war" after U.S. bombers flew over the area in a training drill with the South Korean air force. Meanwhile, Beijing urged all parties to "stay calm and stop irritating each other" on Wednesday after receiving a rare rebuke from Pyongyang, Reuters reported .

Potential consequences

In a recent report, Moody's outlined how the threat of conflict could prompt Seoul to ramp up defense spending — a move that could dent the government's fiscal strength.

Slower growth in investment and consumption as a result of heightened pressure would constrain growth and potentially prompt fiscal stimulus, but lower spending by businesses and households may blunt the effectiveness of such government policies, Moody's warned.

Even in the absence of military conflict, the perceived risk of confrontation among investors and consumers could be damaging. "Intensifying tensions could markedly and durably dent Korea's attractiveness as a place to invest and hire," the Moody's report said.

Elections coming up

The degree of geopolitical strain may evolve after South Korea's presidential elections on May 9, according to Moody's.

File photo of Ballistic rocket is seen launching during a drill by the Hwasong artillery units of the KPA Strategic Force in this undated picture provided by KCNA in Pyongyang on July 21, 2016.
KCNA | Reuters
File photo of Ballistic rocket is seen launching during a drill by the Hwasong artillery units of the KPA Strategic Force in this undated picture provided by KCNA in Pyongyang on July 21, 2016.

Left-leaning candidate Moon Jae-in has expressed interest in engaging with Pyongyang through a variety of measures, including reopening the Kaesong Industrial Complex and reconsidering the deployment of the Terminal High Altitude Area Defense (THAAD) system.

The situation could ease as a result of re-engagement but a more permanent de-escalation will depend on how the new president manages relations with both the U.S.and China, Moody's said.

"Our base case is that tensions will continue to flare up periodically, as has been the case for decades."