Has North Korea Finally Overplayed Its Hand?

There's no shortage of absurdity when it comes to the tension and conflict between North and South Korea that recently rattled world markets.

With a GDP of about $28 billion, North Korea weighs in at about one-thirtieth the size of the South's $830 billion economy. But it is North Korea that has grown accustomed to shaking down its neighbor to extract concessions from the international community, while bolstering the standing of its authoritarian politicians with its military.

As far economic power goes, that would be the equivalent of Chile routinely threatening the United States, and getting away with it.

But even as rhetoric heats up on the Korean peninsula, and haphazard attempts at diplomacy show only limited success, investors should note that things could be changing this time around. There are increasing signs that North Korea has overplayed its hand, and its biggest patron, China, could be mulling cutting it loose.

South Koreans Unready to Turn the Other Cheek

North Korea's biggest advantage in these games of brinkmanship has been that it has very little to lose. While North Korean artillery could ravage the bustling South Korean capital of Seoul, the impoverished North has few sites really worth bombing.

South Korea's response to North Korean aggression has generally been to turn the other cheek. After a brief period of outrage following the sinking of a naval vessel this spring that killed 46 sailors, for example, South Korea even retracted its demands for an apology earlier this month in the hopes of furthering dialogue.

South Korean President Lee Myung-bak was widely praised by international leaders for his restraint.

But the shelling of civilians seems to have flipped the mood of the South Korean public. Anger at the slow and limited response and a new outcry for revenge was followed by the resignation of the head of the armed forces.

South Korea has promised to retaliate to any further aggression and taken concrete steps to backup this position.

"South Korea's military intends to revise its rules of engagement with North Korea by allowing new conditions to punish the enemy, a significant expansion beyond the current equal response requirements which dictate that the military must respond to an attack with the same kind of weapon and firepower the enemy used," global intelligence firm Stratfor wrote, based on a South Korean Defense Ministry report cited by local press.

An Embarrassment to Beijing

Despite North Korea's predictable threats to engulf South Korea in a "sea of fire" as it conducts joint exercises with U.S. forces in the region, its leadership has reason to worry that their situation is changing: China's support of North Korea may be fading fast. Recently leaked diplomatic cables show that Chinese officials are growing increasingly receptive to the prospects of a Korean reunification as Pyongyang continues to lash out.

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Top North Korean aides have been sent to Beijing following the leaks, indicating that the gravity of the situation isn't lost on its regime.

China is a major provider of food and fuel to North Korea, and its support remains key to the leadership in Pyongyang. Yet the uncomfortable prospect of a reunited and U.S.-allied Korea on its border become more palatable giving the North's growing unpredictability. As analysts at political risk consultancy The Eurasia Group have noted, the shelling incident was likely an embarrassment to Beijing ahead of its own high level meetings with the U.S.

The Self-Preservation Instinct of the Kims

In the short run, this could add pressure to the region. This year's aggressive actions, for example, are believed to have been motivated by a desire on the part of North Korean dictator Kim Jong-Il to boost the military credentials of his youngest son and apparent successor, Kim Jong-un.

Standing down from this aggressive posture could be seen as a failure, and failure can have brutal consequences in North Korea. A botched currency reform that exacerbated economic turmoil and internal pressure led to the execution of the finance minister earlier this year, for example.

In the long haul, though, the developments might be constructive for investors who have to constantly worry about North Korean antics. Assuming South Korea gets tougher and China actually withdraws support, Pyongyang may have no choice but to admit the gig is up.

Of course, it's hard to name another regime whose response to traditional sticks and carrots is less seemingly rational than North Korea's. Its leaders, after all, are happy to spend freely on ambitions like nuclear weapons and face sanctions even as their population faces famine.

Still, dominating the politics of a chaotic country that nonetheless can vex the world's major powers requires more of a self-preservation instinct than the regime is often given credit for. While the Kim family's strategy may take a terrible toll on their nation's subjugated population, it makes a twisted sort of sense for them to continue with it, given the prior support they've received from their patrons in Beijing, and the irritated acquiescence they earn from their neighbors in Seoul.