By Kim Jae-won

The diplomatic row over Dokdo, tiny Korean islets which Japan argues it has historical sovereignty claim to, has become a full-blown economic feud with Tokyo declaring that it will no longer buy Korean sovereign bonds.

Korean government officials are responding with their own brand of cattiness, claiming that the recent Japanese move will have little to no impact on the stability of financial markets here. Japan coming through on its verbal threat of severing its current swap agreement with Korea would also be a painful shot in the foot because a decline in the value of the local currency will only improve the price competitiveness of Korean exporters against their Japanese counterparts.

``It’s not that the country is holding a certain amount of bonds and threatening to sell that amount to create a certain level of disruption. Japan is merely saying it doesn’t want to buy Korean bonds but it was unclear from the start about how much of our bonds it will buy anyway,’’ said Strategy and Finance Ministry official Kim Jin-myeong.

The Japanese media reported last week that Tokyo is considering withdrawing its plans to buy Korean state debt in light of the President Lee Myung-bak’s recent visit to Dokdo. The two countries along with China agreed in September to buy each other’s sovereign bonds to stabilize financial markets in case of another global crisis. Korean government officials claim Japan will find itself isolated in the Northeast Asian framework for financial cooperation if it bails on the bond-purchase plan.

Meanwhile, the Ministry of Foreign Affairs and Trade confirmed Monday that the broadened conflict will have no affect on Korea’s ongoing free trade agreement negotiations with Japan. Korea initially considered suspending the talks after Japan’s move to end the currency swap.

The sovereign bond case is the latest incident of the two countries’ economic and diplomatic conflicts sparked by Lee’s trip to the easternmost islets. Japanese Finance Minister Jun Azumi told reporters Friday he is considering adjusting the terms of the currency swap deal with Korea. That could include a decision on whether or not to extend the deal before it expires in late October, he added.

Korea expanded its currency swap line with Japan from $13 billion to $70 billion last year in a bid to secure foreign exchange liquidity. Under the deal, Seoul can exchange its own currency with safer assets such as dollars and yen.

Seoul has similar foreign-currency swap arrangements with China and the Association of Southeast Asian Nations through the Chiang Mai Initiative fund. The country also once held a $30 billion won-dollar swap deal with the U.S., but that expired in 2010.

These arrangements eased concerns over a possible liquidity crunch in Korea by opening channels to secure extra dollars to add to its fast-dissipating foreign currency reserves at the time.

According to the central bank, Korea held $311.4 billion worth of foreign currency reserves at the end of last month. That amount is up from about $200 billion held in the midst of the previous financial crisis.

Market observers doubt Japan will go ahead with its threat. They speculate the threat to close the swap line might just be a "symbolic" move to gain an upper hand in the row.

Even if Tokyo was to close the swap line with Seoul, market watchers said the overall impact on the financial market here will not be significant as things are quite different from when Korea was hit hard by the global financial turmoil.

The local economy was rocked by the global financial meltdown in 2008, as stock and currency markets tumbled on worries dollar funding could dry up amid ever-deepening turmoil.

To prevent such external shocks from swaying the local financial markets and the overall economic conditions again, Korea has focused on strengthening its safety net against possible future crises.