Pakistan's Instability Shakes Up India and Rattles Investors Worldwide - TheStreet

Pakistan's Instability Shakes Up India and Rattles Investors Worldwide

Economic prospects in India have been challenged by the recent coup in Pakistan, straining the already combative relationship between the two nuclear-powered neighbors.
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When Pakistan ushered itself into the nuclear club last year, no one -- particularly its Indian neighbors to the east -- was all that happy.

The country is riddled with factionalism, extremism and militarism. It is poor and overwhelmed by a larger, more powerful country, India, which started the subcontinent's arms escalation with its own nuclear blast and crossed swords with Pakistan over a disputed border region during the summer.

Worst of all, Pakistan is unstable.

Just how unstable was made clear Tuesday, when Gen. Pervez Musharraf staged a coup after being fired by Prime Minister Nawaz Sharif. Sharif is now reportedly under house arrest and the military has control of television outlets and airports.

Not surprisingly, the developments have reverberated around the world. While stock traders are also looking at interest rates and earnings, the coup d'etat has contributed to pushing the

Dow Jones Industrial Average

more than 400 points, about 4%, lower. Bourses throughout Asia and Europe have also sagged.

Outside Pakistan itself, no country was more affected than India, which was beginning to look like the new, hip Asian market for investors. The country has a booming software industry, driven by companies like

Infosys Technologies

(INFY) - Get Report

and

Shri MM Softek

.

The country was looking so good that investors celebrated the newly elected coalition government of Prime Minister Atal Behari Vajpayee, who is expected to kick-start stalled economic reforms, by pushing the benchmark

Bombay Sensitive Index

to a record high of 5,031.78 on Monday.

Indian ADRs, unsurprisingly, dropped on the news, though they recovered much of that later in the day. The Bombay index wilted 24 points on Wednesday.

"There was some euphoria after the elections, but now the situation in Pakistan is alarming," says Punita Kumar, portfolio manager of the

CIBC World Markets India Fund

. "It does raise some fear of another escalation between India and Pakistan over the short term."

Over the summer, Pakistan suffered a humiliating defeat to India over Kashmir -- a loss that hobbled Sharif's reputation. The current concern: Musharraf may choose to whip up tensions between the bitter neighbors in an effort to regain face and assert his control over Pakistan. The fears are not unwarranted; villagers on the Pakistan-India border are fleeing to less risky areas.

Even if Musharraf chooses to pursue regional stability, India's new government will have its arm twisted. To assure political popularity, Vajpayee's government, elected in the world's biggest democracy, will need to maintain or even increase defense spending, which accounts for half of all tax revenue and totals 3% of

GDP

, according to

Moody's Investors Service

. Last week, Moody's raised its outlook for India from stable to positive.

To accommodate the larger defense bill, India may be forced to lower spending on vital social programs aimed at combating India's staggering health, poverty and illiteracy problems, or sacrifice tight fiscal accounts.

Hope remains, however, that India's government can direct its attention to trimming the public sector on the federal, state and public enterprise level. Then the country will be able to support the show of arms and progressive social programs while improving its overall budget and appeal to foreign investors. Such streamlining will test the political courage and dedication of the federal and state governments.

And Indian companies are experiencing an upturn, which is likely be left unscathed by the situations in and with Pakistan as long as the situation remains at the simmering point. Technology firms in particular are considered attractive investment opportunities, having shifted sector focus from Y2K preparedness to e-commerce and Internet-related work.

Christopher Lively, portfolio manager of

Pioneer's Indo-Asia Fund

, says the large pool of qualified English-speaking software engineers coupled with the growth of the software export industry makes technology the growth sector to bet on. For example, industry darling Infosys, an IT services company that writes proprietary software, traded slightly lower in the wake of the coup, but is still up 300% since March, when it listed.

Over the next two to three months, tensions are likely to mount across the India-Pakistan border, but fears of a full-scale conflict are low, say analysts. Indeed, India's biggest challenge may not be its nuclear neighbor, but striking a delicate balance of defense, conciliation and visionary reform.