North Korea threatened to close the last road link with the South if Seoul goes ahead with propaganda broadcasts across the militarized border, as Washington pressured China to help persuade the North to change its ways.
The mounting antagonism between the two Koreas has shaken investors, uncertain how far they are ready to take their bitter rivalry after the South accused the North of torpedoing one of its warships.
On Wednesday, shares and the local currency looked much more stable after sharp falls the previous day, but analysts said both remained under a cloud from North Korea, as well as the fallout from euro zone problems.
The won is now in its longest losing streak for 10 months while the stock market, though slightly higher, saw foreign net selling for the eighth consecutive session.
A day after saying it would cut all ties with the South, Pyongyang said it was considering closing a road link with the South which would threaten production at a joint industrial park that is a lucrative source of income for the North's government,.
"The South Korean puppet war-like forces would be well advised to act with discretion, bearing deep in mind that such measures of the KPA (army) will not end in an empty talk," North Korea's KCNA news agency quoted a top official as saying.
Washington is looking for ways to avoid the issue collapsing into conflict and U.S. Secretary of State Hillary Clinton pressed Beijing to coax its North Korean ally into changing course.
"There is a different path for North Korea and we believe it's in everyone's interest, including China, to make a persuasive case for North Korea to change direction," she told reporters in Seoul.
China, which almost single-handedly props up the North Korean government and its destitute economy, again called for calm and dialogue.
It has refused to give its backing to an international investigation that last week concluded North Korea in March sank the South Korean Cheonan corvette, killing 46 sailors.
Beijing is certain to block attempts to impose new sanctions on its ally which means the United States may have to accept no more than a carefully worded rap over the knuckles for Pyongyang.
Clinton said that the crisis brought on by the North's sinking of a South Korean warship required a strong but measured response and said Washington was considering additional options to hold Pyongyang accountable.
The South has announced its own set of measures against Pyongyang for sinking the Cheonan. Those include resuming, after a six-year lull, the setting up of speakers near the border to broadcast propaganda and send messages across by balloon.
Despite its announcement that it was severing all ties with the South, the North on Wednesday allowed workers from across the border to enter their joint industrial park.
The move suggests the isolated North is being careful not to go so far as to cause material damage to itself despite some of the most ferocious rhetoric directed against the South in years.
But if it does cut the road link to the Kaesong industrial park, it will be unable to function.
Analysts say both Koreas, who have never repeated the open conflict of the 1950-53 Korean War, were unlikely to let their current hostility turn to war.
Apart from Kaesong, there is little economic relationship left between the two, their ties almost frozen since the South's conservative President Lee Myung-bak took office in 2008.
"North Korea is not closing up Kaesong immediately because it is saving the cards it needs in order to play the game," said Jang Cheol-hyeon, researcher at the Institute for National Security Strategy.
By paying the workers' wages directly to Pyongyang, Kaesong is one of the few major legitimate income sources for the North's secretive leaders, worth tens of millions of dollars a year.
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