Tensions in North Korea have overtaken Iran as the major geopolitical risk of the year, according to a report from Citi Research, a division of Citigroup Global Markets.
Pyongyang warned earlier this week its military had been given final approval to launch military strikes against the U.S., including the use of nuclear weapons. The Pentagon meanwhile said on Wednesday it would deploy a missile defense system to the U.S. Pacific territory of Guam to strengthen the region's protections against a possible attack.
In the past, rhetoric from North Korea has been dismissed as sabre rattling, but the recent escalation in tensions on the North Korean Peninsula has led to heightened concern in financial markets. South Korea's benchmark Kospi index fell to a six-month low on Friday as investors fretted over developments in the North.
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Citigroup warned investors not to underestimate the impact of North Korea.
"In our view, North Korea has overtaken Iran as the year's biggest potential flashpoint," said Citi. "The stakes have increased markedly since the last period of heightened tensions in 2010, as have many of the players."
"Most notably, there's new leadership in China, a more muscular Japanese foreign policy, and a United States rapidly realigning security and trade relationships with its Asian partners, not to mention a new 20-something leader in Pyongyang. With this in mind, developments on the Korean Peninsula bear close attention."
Concerns over Iran's nuclear program have faded by comparison, the report said.
In recent years tensions between Iran, the world's fourth largest oil producer, and the international community over its disputed nuclear program have been a major headwind for investors, with the price of oil spiking when tensions have flared.
But Citi said that fears over Iran's nuclear program had been eased by progress in international negotiations.
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"Even as Iran's nuclear program continues to raise international concern, the P5 1 process means that efforts toward high-level diplomacy are ongoing, containing the risks," Citi analysts said in the note, referring to a group of countries that include the U.S., China and Britain making diplomatic efforts with Iran.
According to Citi, this week's sell-off in South Korean shares demonstrates that investors are taking the North Korea threat more seriously.
It says that in 17 North Korean "shocks" since 1996, the Kospi index has only reacted eight times, falling around 0.3 percent each time. In contrast, the Kospi fell 1.2 on Thursday and a further 1.6 percent on Friday.
(Read More: Won Drops to 7-Month Low, Socked by North Korea)
Citi warned that foreign direct investment (FDI) in South Korea could also be impacted by the tensions. It highlighted the 20 percent slump in FDI following heightened North Korea tensions in 2009 and 2010, following the second nuclear test and the sinking of the South Korean naval ship Cheonan.
However, it acknowledged that the contraction in FDI may have also have occurred as a result of lackluster global growth and risks in the euro area.
Despite the concerns, Citi added that North Korean brinkmanship could in fact present buying opportunities for investors.
"Heightened North Korean tensions do not always have negative impacts on markets and have occasionally presented buying opportunities, but any shock that affects sentiment should not be ignored," Citi said.