SEOUL (Reuters) - North Korea on Tuesday threatened military action if the South continued to violate its waters off the west coast, adding to escalating tension on the peninsula following the sinking of a South Korean warship by the North.
The increasingly war-like rhetoric hit Seoul's financial markets, prompting financial policymakers to hold an emergency meeting on Wednesday to look for ways to calm investors.
"Should the South side's intrusions into the territorial waters of our side continue, the DPRK (North Korea) will put into force practical military measures to defend its waters as it had already clarified and the south side will be held fully accountable for all the ensuing consequences," North Korea's KCNA news agency quoted a senior official as saying.
The furious war of words -- the North referred to the South's government as "military gangsters, seized by fever for a war" -- follows a report by international investigators last week which accused the hermit north of torpedoing the Cheonan corvette in March, killing 46 sailors.
On Monday, South Korean President Lee Myung-bak cut trade with his impoverished neighbor and blocked its commercial ships from sailing through the South's waters.
He also plans to take the issue to the U.N. Security Council.
Most analysts doubt either side would risk a war, which would be suicidal for the North and economy-ruining for the South.
The initial markets falls were triggered by a story by the South's Yonhap news agency quoting a local report that the North was gearing up for war. It later emerged that the report said only that the North would fight back if it was attacked.
"The Yonhap report ... chilled investor sentiment as it highlighted South Korea's geopolitical risks. And the timing for such news could not be worse, as market sentiment was already shaky with renewed euro zone financial fears," said Hwang Keum-dan, a stock market analyst at Samsung Securities.
Key economic and financial authorities will meet early on Wednesday to discuss ways to stabilize local financial markets.
Stocks on the main index tumbled to their lowest close in 15 weeks and the currency slid to a 9-month closing low against the dollar, but came off its lows after news of the emergency meeting.
Some in the market saw the selling as overdone and triggered mostly by foreign selling.
"North Korea and related risks have always been there. It is like telling investors to quit the Japanese market because it has earthquakes. War is wanted neither by the North nor the South," one fund manager at a foreign investment management house said.
Both sides have stepped up their rhetoric over the Cheonan incident, one of their deadliest since the 1950-53 Korean War.
The North charged South Korea's government with fabricating the issue, partly to help the ruling party in next week's local elections -- important to cement President Lee's power in the second half of his single five-year term.
The incident appears to have done nothing to dent Lee's popularity, which one recent opinion poll shows running at well over 40 percent, unusually high for recent South Korean presidents halfway through their term.
A strong showing for Lee's party in the June 2 local election, which many expect, will give him greater authority to push aside a fragmented opposition in parliament and continue with sweeping pro-business reforms.
Since taking office in 2008, Lee has sometimes struggled to push through reforms he says are needed to bring more vitality to Asia's fourth largest economy, which depends heavily on manufactured exports.
His rule has also seen relations with the North turn increasingly chilly as he turned his back on a decade of generous aid to the North by his predecessors which had failed to end its attempts to build nuclear weapons.
PUSHED TOO FAR?
Some worry pushing North Korean leader Kim Jong-il too far may leave him little choice but to fight back to try to save his family's more than 60-year hold over the destitute country as he tries to secure the succession for his youngest son.
Analysts say the main risk is that small skirmishes along the heavily armed border could turn into broader conflict.
China, the North's only major ally and which effectively bankrolls its economy, has studiously tried to keep out of the fray, urging calm and refusing to voice support for the international report on the Cheonan sinking.
It means that South Korea has almost no chance of winning further U.N. sanctions against its neighbor.
The issue is certain to dominate talks in Seoul on Wednesday with visiting U.S. Secretary of State Hillary Clinton, who is arriving from Beijing.
The United States, which backs Seoul, has said the situation was "highly precarious" and said it would take part in a joint naval exercise with the South.
(Additional reporting by Christine Kim, Jungyoun Park, Yoo Choonsik, Kim Yeon-hee and Jack Kim in Seoul and Linda Sieg in Tokyo; Editing by Paul Tait)