By Jack Kim

SEOUL, Aug 2 (Reuters) - North Korea faces more sanctions
as punishment for its alleged sinking of a South Korean navy
ship, with the United States planning financial and travel
restrictions on companies and individuals suspected of
involvement in illicit activities. Pyongyang has reacted
angrily.

Sovereign 5-year credit default swap spreads for South
Korea have tightened to around 100 basis points, after surging
well above 150 during tense times in May and June.

Following is a summary of key South Korea risks to watch:

* THE NORTH

Tensions with the North have ratcheted up the risk level
across north Asia, which accounts for one-sixth of the global
economy. The greatest risk would be war. North Korea could lob
thousands of artillery rounds into the Seoul region, home to
about half South Korea's population, and fire missiles at
cities in South Korea and Japan, causing crippling economic
damage.

Analysts believe war to be unlikely. North Korea's obsolete
conventional armed forces and military equipment mean quick and
near certain defeat if it wages full-scale war, and Pyongyang
is well aware of its limits. Even though it has exploded
nuclear devices, North Korea has not shown it has a working
nuclear bomb. Experts say they do not believe the North has the
ability to miniaturise an atomic weapon to place on a missile.

Moreover, South Korea has made clear it will not retaliate
after findings showed it was a torpedo fired by a North Korean
submarine that sunk the Cheonan corvette, killing 46 sailors.

The greatest risk that could fuel armed confrontation lies
in small-scale skirmishes that might develop into larger
conflict. Another risk could be a buildup of U.S. forces that
will be seen by the North as a sign of imminent invasion,
something leaders in Pyongyang are said to be genuinely afraid
of.

Besides war, another risk scenario for markets would be the
implosion of the North Korean regime, leading to sudden
reunification. Most estimates say it could cost Seoul more than
$1 trillion to absorb its impoverished neighbour.

What to watch:

-- The leadership succession. Kim Jong-il's youngest son is
believed to be in training to take over power from his father,
who by all appearances is firmly in charge of the reclusive
state but is clearly in failing health. South Korea's spy chief
has said that there is urgency in the North to move on with
succession plans because of Kim's questionable health. The
North has called an extraordinarily rare session of its ruling
Workers Party general convention for September for what is
widely seen as an announcement of Kim Jong-un's nomination to a
key party post. Such a move will be in line with how Kim
Jong-il began on the road to power three decades ago to
eventually take over from his father and state founder Kim
Il-sung in 1994.

-- Clues on the stability of the North Korean regime. South
Korean assets would dive if it seemed the North was imploding
and reunification was likely. Some analysts see the torpedo
attack as a sign of desperation. The North's decision to
revalue its currency in late 2009 sparked rare internal
protests, and Kim Jong-il's efforts to pushes through new
measures to reassert control over the economy may further
destabilise his regime.

* FALLOUT FROM SHIP ATTACK

The sinking of the Cheonan in late March has the potential
to spark conflict with the North and the expected addition of
more sanctions by the United States is certain to escalate
Pyongyang's anger. A key U.S. arms control envoy, Robert
Einhorn, and the Treasury Department's terrorist financing
section chief Daniel Glaser are visiting Seoul to coordinate
sanctions that will be aimed at cutting off earnings from
illicit activities.

Glaser was behind the U.S. measure in 2005 freezing the
North's assets at a Macau bank, which angered Pyongyang and
drove it to boycott six-party disarmament talks which had just
reached a breakthrough deal to disable the communist state's
nuclear programmes in return for massive economic and energy
aid, beginning with the shipment of 1 million tones of heavy
fuel oil. U.S. Secretary of State Hillary Clinton said the new
sanctions are aimed at cutting off the flow of cash to the
North's leaders.

What to watch:

-- Einhorn may unveil the details of fresh U.S. sanctions.
They will likely involve freezing of assets believed to be tied
to the North's illicit activities, imposing restrictions on
financial institutions involved in those businesses and a ban
on travel for North Korean officials suspected of involvement.

-- South Korea has yet to implement the strongest of the
measures it has announced, such as propaganda broadcasts
through loudspeakers set up along the border, which the North's
military has threatened to open fire on.

-- Trade across the border has slowed, and movement of
people has also been cut back sharply.
-- South Korea says it will clamp down on its land and sea
border with the North, and that raises the risk of further
clashes which, with its more advanced weaponry, the South would
probably win. More losses would embarrass North Korea's
powerful military and put pressure on Pyongyang for a
counter-strike.

* GOVERNMENT EFFECTIVENESS AND ECONOMIC REFORM

After suffering a collapse in popularity upon taking office
just over two years ago, President Lee Myung-bak has seen a
surge in his support as South Korea's economy emerges from the
global downturn more quickly than other major economies.

The government has upgraded its 2010 job creation target to
300,000, and the finance ministry recently raised its GDP
growth forecast for 2010 by 80 basis points to 5.8 percent.

But Lee's plans for job creation and his business-friendly
reform agenda have been blocked for months in parliament due to
a row over plans to move some ministries to a new
administrative capital. A vote in June marked the end of the
plan by rejecting Lee's initiative. It also brought the end of
the tenure of Prime Minister Chung Un-chan, an economist who
had been expected to take charge of Lee's pro-business policy
agenda but has announced his resignation. Lee is expected to
appoint a replacement and also reshuffle the cabinet and name
new people to the national security portfolios.

Lee's ruling Grand National Party had a strong showing in
parliamentary by-elections in late July, giving fresh momentum
for his legislative agenda as he begins the second half of his
single five-year term. A new cabinet is likely to provide a
fresh push for his reform plans.

What to watch:

-- A new parliamentary session. The GNP and the opposition
are likely to agree to hold an extra session of parliament. It
should provide the greatest chance Lee has had in several
months to process a legislative agenda that includes tax cuts.
But it is likely to fall short of a vote to ratify a free trade
deal with the United States.

-- Labour laws and policies. A key indicator of Lee's
political clout can be seen in his ability to push through his
plans on job creation and adding greater flexibility into what
is regarded as a rigid labour market.

-- Opposition in disarray. A power struggle in the
Democratic Party is likely to intensify before it holds a
national convention to pick a new leader in September.
(Editing by Andrew Marshall)