North Korean leader Kim Jong-il reportedly told his military it might have to go to war if attacked after the sinking of a South Korean ship, as escalating rhetoric between the Koreas rattled Seoul’s financial markets.

Few analysts expect conflict despite increasingly furious words after the South announced it would punish its hermit neighbour for torpedoing one of its warships, killing 46 sailors.

But when a local media report said the North was readying to fight, it was enough to help knock the wind out of share prices and the South Korean won.

It later emerged a local website (www.nkis.kr) quoted by the South’s Yonhap news agency and which had unnerved markets was in fact reporting on comments made on May 20, before the South announced a series of measures against its neighbour for sinking a warship in March, killing 46 sailors.

“We do not hope for war but if South Korea, with the U.S. and Japan on its back, tries to attack us, Kim Jong-il has ordered us to finish the task of unification left undone during the … (Korean) war,” the website quoted the North’s broadcast as saying.

The comments are in line with previous ones by the North that it is ready to defend itself if attacked.

One fund manager at a foreign investment management house said local investors were actually buying and it was foreign investors who looked more worried and were 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.

Late last week, the South said a report by international investigators showed the North had torpedoed the Cheonan corvette near their disputed sea border.

President Lee Myung-bak’s government announced on Monday that it would ban all trade with the North over the sinking and stop its commercial ships using South Korean waters, moves likely to further squeeze the already destitute North Korean economy.

Both sides have stepped up their furious rhetoric over the 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 puppet authorities (the South’s government) are the arch criminals who should pay a dear price for the recent sinking of the warship,” North Korea’s KCNA quoted the Rodong Sinmun newspaper as saying.

POPULARITY HOLDS

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.

Many analysts say there is too much at stake for either of the Koreas to dare go to war. The North’s million-strong military may be one of the world’s largest standing armies but is no match for the better equipped South Korean and U.S. forces.

The South too is aware that any major conflict will only damage its own economy and frighten off investors and on the streets of Seoul there was little obvious concern.

“I don’t think there is going to be a war on the peninsula, largely because the parties involved have too much to lose by risking a war. I think the speech by President Lee yesterday was more of a way to pressure the North rather than a real threat,” said Hwang Ik-jun, a 23-year-old student.

PUSHED TOO FAR?

But 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 sanctions against its neighbour when, as it says it will, it raises the issue with the U.N. Security Council.

The United States, which backs Seoul, said the situation was “highly precarious” and it would take part in a joint naval exercise with the South.

The reaction of financial markets has been jumpy, coming at a time when there are worries about the impact of the euro zone troubles on emerging economies like South Korea’s.

“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 market analyst at Samsung Securities.

“The stock market will have a hard time recovering until these two big uncertainties are somewhat resolved,” she said.

The main Seoul share index closed at a 15-week low.

The won also stumbled. It had its worst day for 14 months also on a combination of euro zone and North Korea concerns and forcing the authorities to intervene to prevent too fast a fall. (Additional reporting by Christine Kim, Jungyoun Park, Yoo Choonsik and Kim Yeon-hee in Seoul and Linda Sieg in Tokyo; Editing by Jerry Norton)