Pakistan instability poses fresh investment risks

By Sujata Rao and Peter Apps - Analysis

LONDON (Reuters) - Pakistan's brief period as a destination for adventurous investors seems over for now, as the killing of opposition leader Benazir Bhutto brings fresh instability to an already volatile nuclear-armed nation.

Bhutto was assassinated on Thursday ahead of January 8 elections that were seen ushering in democracy after a decade of military rule and promoting policies that -- vitally for investors -- would include a commitment to stamp out Islamist militants in areas bordering Afghanistan.

But hopes now lie in tatters that leading Pakistani politicians can create a bulwark against militant Islam and bring in a stable government allied to the West.

"This is the worst possible scenario for foreign investment. Probably there are many months of volatility ahead and this environment of chaos is perfect for Islamic militants," said Luis Costa, head of emerging debt at Commerzbank in London.

"In the first half of 2007, we saw Pakistani assets outperforming which brought in real money managers," Costa said. "We will probably now see a reversal of this trend."

For the past couple of years, Pakistan has lured growing amounts of foreign cash -- the Karachi stock market is up 50 percent year-to-date, making it Asia's top performing index.

While less than 10 percent of this $70 billion-plus market is so far held by foreigners, flows have been rising especially from the oil-rich Middle East, as the attraction of a fast growing economy outweighed the rising political risks.

Foreign direct investment too has been on the up. It almost doubled in the last fiscal year, while in the first five months of the 2008 July-June fiscal year it rose by almost $500 million to $1.7 billion, according to central bank data.

Part of this is due to President Pervez Musharraf's liberal economic policies and the semblance of stability that his firm military rule brought. Secondly, Pakistan has been lifted by the same tide that buoyed most emerging markets throughout 2006 and 2007.

"So far Musharraf has delivered reasonably well -- the stock market has gone up, investment has gone in and the economy has done OK," said Rashna Writer, principal analyst at The Risk Bureau, a consultancy in London.

"The problem for Pakistan is that its (civil) institutions have been weakened to the point of being feeble," she said, referring to the parliament and judiciary.

FEARS

Bhutto's death has already sparked rioting and deaths and fears are that this will intensify in coming weeks, possibly even pitching the nuclear-armed country into civil war.

Pakistan's share and currency markets, closed for three days, have not yet reflected the shift in sentiment. But foreigners have been hedging their exposure to Pakistan, with the cost of buying five-year protection via credit default swaps rising some 100 basis points since Bhutto's assassination.

The yield on Pakistan's 2017 dollar bond is now almost 600 bps over U.S. Treasuries, compared to 400 bps last week and the 250 bps premium at which it was issued in May.