Moody's says that the escalation of tensions between the North Korean regime and the new US administration broadens the nature of geopolitical risk for Korea (Aa2 stable), which is the most salient event risk for the sovereign and a constraint on the rating.

A higher probability of conflict on the peninsula -- albeit still at a very low level -- is credit negative. It is consistent with Moody's 'Moderate (-)' assessment of geopolitical risk.

Moody's conclusions are contained in its just-released report, "Government of Korea - North Korea-US Tensions Broaden Credit-Negative Geopolitical Risks".

Specifically, a further sustained escalation of tensions would affect Korea's economic and fiscal strength negatively. Slower growth in investment and consumption would weigh on overall growth and could necessitate larger fiscal stimulus measures.

However, Moody's notes that past episodes of rising tensions have not deterred investment or consumption in Korea and have not unsettled its financial markets.

In the current episode, Moody's further assumes that spending decisions will be largely unaffected, allowing the economy to continue to grow at a robust rate. Moody's forecasts GDP growth at 2.5% this year and 2.0% in 2018, which is in line with the rating agency's assessment that Korea's Economic Strength is 'Very High'.

A marked increase in the probability of conflict would likely result in higher defense spending by Korea, potentially denting its fiscal strength. In such an environment, conflict risk would affect the spending decisions of businesses and households and, as a result, blunt the effectiveness of government policies.

Furthermore, even in the absence of outright military conflict, a rise in investor and consumer perceptions that the risk of confrontation has increased could have negative credit implications.

Should the economy weaken, partly as a result of heightened geopolitical uncertainty, Moody's expects that the government would partly buffer the shock through some further easing of fiscal policy. With government debt at less than 40% of GDP, the government has room to provide temporary support to the economy.

However, prolonged and intensifying tensions could markedly and durably dent Korea's attractiveness as a place to invest and hire. In this case, the country's very high economic strength would suffer an erosion, with an accompanying weakening in competitiveness and lowering in growth. Fiscal policy easing would only have limited effects on such a structural negative shock and Korea's fiscal strength would diminish.

The nature and degree of geopolitical risk may evolve after Korea's presidential elections on 9 May. Mr. Moon Jae-in, the leading candidate according to the polls, has expressed interest in pursuing the "Sunshine Policy" of engaging the North, which past administrations had adopted.

In such a context, Moody's believes that effective re-engagement with Pyongyang could be credit positive, but this is not part of its base case scenario.

Moody's rating for Korea further takes into account the tail risk of a sudden collapse of the regime in the North, which would precipitate large, unprovisioned fiscal costs for the South.

Unpredictable actions from North Korea (unrated) and a US (Aaa stable) foreign policy stance yet to be ascertained over time imply that the probability of outright conflict on the Korean peninsula has increased somewhat, albeit remaining very low.

Moody's conclusion is based on the rating agency's view that the South's military alliance with the US is strong and credible.