But barring a broader conflagration the turmoil is unlikely to spark a slump in South Korean assets due to the countrys robust economic fundamentals, analysts said.
We see a strong chance of further a pullback in the Korean won and stock market in the days ahead as more details about the incident emerge, particularly if public opinion in South Korea puts pressure on the government there to take a stronger stance, said Brian Jackson, a Hong Kong-based analyst with RBC.
But South Koreas positive growth outlook and strong external position boosts the medium-term market outlook in South Korea.
The Korean won lost 2.5% following reports that North Korea fired artillery at South Koreas Big Yeonpyeong island in the Yellow Sea, prompting reprisals from the South. Indias benchmark 30-share index, BSE Sensex, closed 1.3% lower.
Hong Kongs Hang Seng Index dropped 2.67% in reaction to tensions in the Korean peninsula. Asian markets were also rattled by concerns that other European nations may need financial support, following Irelands emergency bailout package this week.
Alastair Newton, senior political analyst at Nomura, said Tuesdays flare- up is potentially one of the most serious incidents that we have seen in the region for many years coming in the wake of the sinking a South Korean warship in March.
But he said South Korea has enough policy bullets to head off a market slump. Korean business and consumer sentiment could take hit if tensions escalate further, but a weaker currency would boost the countrys export competitiveness and trade balance, he added.
The Bank of Korea has a record stockpile of $293 billion of foreign exchange reserves, which provides the authority with sufficient ammunition to provide emergency liquidity for financial markets. In addition, the BoK could restart currency swaps with the US Federal Reserve in the event of a dollar illiquidity crisis.
Deputy governors of the Bank of Korea and government agencies will hold an emergency meeting Wednesday to discuss the market impact of regional tensions and possible policy responses, the finance ministry has said. South Koreas Financial Services Commission and Financial Services Supervisory Service has also said regulators can take pre-emptive measures to forestall a further market sell-off.
Jackson said the tensions did not change a positive outlook on Koreas currency. Dips in the wons value which Jackson said is currently undervalued by between 10% and 20% offer investors buying opportunities, he said. South Korean assets already have political risk premia priced in while appreciation pressures on the Chinese yuans will strength the won.
South Koreas government could scrap capital inflow taxes in the event of sell-off in Korean assets, said Newton. Before today's incident, the government was poised to reinstate a 14% tax on interest income from treasury and central bank bonds and an initial 20% capital gains levy on their sale in the primary markets. The moves are intended to curb foreign inflows of capital to stem currency appreciation pressures and the risks associated with excess financial leverage.
South Korean markets last sold off on May 20 as regional tensions flared following an investigation which concluded that a North Korean torpedo had sunk South Koreas ROKS Cheonan navy vessel in March. This led to a 9% drop in the Korean won against the US dollar in the days following the report.
Newton said it remains unclear whether Tuesdays incident represents an attempt by the North Korean leadership to gain leverage over the international community or if the attack was undertaken by rogue military commander.
In recent weeks, rumours have surfaced North Korea is preparing a nuclear test while at the same time looking to return to the negotiating table with world powers over its nuclear program.