By Jon Herskovitz

SEOUL, April 4 (Reuters) - After a week of taunts and insults, North Korea is expected to step up its threats against the South, but its military flaws and the controlling hand of China will stop it from going too far, experts say.

They expect no let up in the North's heated rhetoric and tests of the South's military as the irritable and impoverished state tries to push new President Lee Myung-bak into dropping his hard line toward Pyongyang and returning to the free flow of aid it received for a decade under his two predecessors.

The next steps might be naval skirmishes and test-firing more short-range missiles, but ultimately the North's hands are tied, analysts said.

"Their options are very limited and I doubt they have any leverage," said Lee Dong-bok, a senior associate in Seoul with the CSIS think tank. "It's a barking dog."

North Korea has warned twice in the past week that it is ready to attack South Korean ships patrolling in disputed Yellow Sea waters off the west coast. Dozens of South and North Korean sailors were killed in two skirmishes in 1999 and 2002.

Experts said the North may be hesitant to attack because the South's warships have greater fire power, better armour and far superior targeting systems.

"In a military situation where parties are prepared, South Korea cannot be outmatched," said Lee.

North Korea is one of the world's most-militarised states. The bulk of its 1.2 million-man army is stationed near the border with the South, and thousands of pieces of artillery stand ready to strike Seoul, just 50 km (30 miles) from the border.

The commander of the 28,000 U.S. troops stationed in South Korea to support its 670,000-strong military said their forces would quickly defeat invaders from the North, who have obsolete weapons and little fuel to move its antiquated machinery.

North Korea could be considering another missile test, after test-launching short-range, ship-to-ship missiles in the Yellow Sea last week.

Experts said the South would downplay any such test, as it did last week's launches. If the North tried to increase stakes by test firing its longer-range ballistic missiles, it would face sanctions and a global rebuke.

FURIOUS RHETORIC

But there is no sign so far the North has gone any further than furious rhetoric in what many analysts see as an attempt to pressure South Korea and its U.S. ally into making concessions.

North Korea could try to restrict business at a factory park and mountain resort run by the South and located in the North.

These projects, set up by the two presidents who ruled before Lee, provided the cash-strapped North with millions of dollars a year, money it stands to lose by shutting them down.

Market players have grown used to the North's bluster and taunts, and while many are watching closely, they see no reason yet to change their minds about investing. The so-called "Korea Discount" factors in the risk of putting money into a potential warzone.

Analysts say the North is likely to be restrained from escalating its fiery rhetoric into something more dangerous by China, its only significant ally.

China, embarrassed by protests over Tibet and Darfur, would also want to prevent North Korea from becoming another headache ahead of the Beijing Olympic Games in August, its launching party as a world power.

In addition, North Korea, which battles chronic food shortages, is likely to face a crisis this year due to flood damage to its farms in 2007, cuts in the massive food aid the South typically sends, and higher grain prices that could lead China to cut its handouts.

"This is destabilising internally," said Daniel Pinkston of the International Crisis Group in Seoul.

"One way to brace for that and to manage that problem is to fan the flames of the external threats. If you keep sabre rattling and tensions high externally, there are benefits to the regime," he said. (Additional reporting by Lee Jiyeon; Editing by Jerry Norton)

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