South Korea to take ship case to U.N

SEOUL (Reuters) - South Korea on Monday cut off trade and access to its waters to North Korea and demanded Pyongyang apologise for the sinking of a naval ship which has pushed tension on the peninsula to its highest in years.

In a nationally televised speech, President Lee Myung-bak said he would take the issue to the U.N. Security Council.

Fears the escalating rhetoric could turn into open conflict on the divided Korean peninsula has weighed on investors in the South, Asia's fourth biggest economy.

The won fell more than two percent to an eight-month low in early trading, though it later recovered a little.

"I solemnly urge the authorities of North Korea ... to apologise immediately to the Republic of Korea (South Korea) and the international community," President Lee Myung-bak said in a nationally televised address. Late last week, a team of international investigators accused North Korea of torpedoing the Cheonan corvette in March, killing 46 sailors in one of the deadliest clashes between the two since the 1950-53 Korean War.

"North Korea's goal is to instigate division and conflict," said Lee, speaking from the country's war memorial in the capital Seoul. "It is now time for the North Korean regime to change."

Lee said the South reserved the right to defend itself if Pyongyang wages aggression. The North said much the same to its neighbour last week when it denied involvement in the sinking.

As expected, he said Seoul would take the issue to the U.N. Security Council which it hopes will impose more sanctions on the reclusive state.

South Korea will also cut off all remaining trade with the North and barred its commercial ships from entering South Korean waters.

AID FOR CHILDREN

He promised to continue aid for North Korean children and stopped short of shutting down a joint factory park inside the North, the only remaining significant economic relationship between the two Koreas.

Local financial markets took some relief from Lee's comments which steered clear of any suggestion of military retaliation.

South Korean stocks and the won slightly cut losses while treasury bond futures extended gains as traders played down the chance the tensions with the North would develop enough to spark a massive capital flight.

"It's not that tensions with North Korea will be cleared up in one day but the speech was worded in such a way as to help reduce investors' jitters," said Yoon Yeo-sam, a fixed-income analyst at Daewoo Securities.

Kwak Joong-bo, a market analyst at Hana Daetoo Securities, echoed that view.

"South, North tension is certainly not positive, but given historical trends, losses that markets suffer over this will be brief, unless a drastic situation takes hold. By drastic, I mean war. I do not think war is likely though," he said.

The moves by the South will, however, further tighten the squeeze on North Korea's economy, already badly hit by mismanagement and international sanctions for past nuclear and missile tests.

Perhaps mindful of going too far in his condemnation of the North, Lee in his speech did not name North Korea's hardline leader Kim Jong-il who many believe sanctioned, if not ordered, the attack on the Cheonan.

South Korea can be sure of a sympathetic hearing from permanent U.N. Security Council members the United States and Britain, both of which sent officials to help the investigation into the sinking.

WINNING OVER CHINA

Much more difficult will to be to win over China, which effectively bankrolls North Korea's ruined economy and has so far declined to be drawn on the question of blame over the sinking.

Chinese premier Win Jiabao will hold talks with Lee in Seoul late this week.

Washington, struggling to keep its own relations with China on an even keel, has called for an "international response" to the sinking. It has yet to specify what that might mean.

The U.N. sanctions North Korea already faces for past nuclear and missile tests are sapping what little bounce is left in a crippled economy that can barely feed the population and has relied heavily on weapons exports to earn foreign currency.

Analysts say China is willing to prop up the North Korean government rather than risk the isolated state's implosion spilling across its border and may be unwilling to further sanction Pyongyang.

(Additional reporting by Yoo Choonsik; Writing by Jonathan Thatcher; Editing by Jerry Norton)