World's fastest-growing economy set to survive Pakistan friction

[NEW DELHI] Relations between India and Pakistan have entered their worst phase in more than a decade, but the likelihood of a broader conflict is remote and analysts suggest the economic impact on South Asia's two largest economies will be limited.

Security agencies in major Indian cities and towns are on alert for any attack in retaliation for the army killing militants in Pakistan, the Press Trust of India reported, citing the home ministry.

The directive comes after the government shifted villagers living along the border with Pakistan in the northern states of Jammu and Kashmir and Punjab.

India said Thursday it had conducted surgical strikes on what it called terrorist launchpads inside Pakistan, after a deadly strike last month killed 19 Indian soldiers in the disputed Himalayan region of Kashmir.

News of the strikes - which Pakistan called an "illusion" to cover cross-border shooting - sent Indian stocks and the rupee sliding but is unlikely to derail growth in India, now the world's fastest-growing major economy. Instead, Prime Minister Narendra Modi is set to continue his efforts to isolate Pakistan internationally and examine other ways to retaliate without sparking a conflict between the nuclear-armed rivals.

"Elevated tensions alone will not impact either economy or lower the attractiveness of either market to potential foreign investors," said Sasha Riser-Kositsky, an Asia analyst at political risk firm Eurasia Group. "The Indian government is likely to stick to its effort to isolate Pakistan diplomatically rather than risk a military escalation that could more severely rattle markets and deter corporate investment."

India's US$2.1 trillion economy is Asia's third largest, and its growth is expected to keep surpassing most major peers, according to Bloomberg surveys. Local assets have rallied as foreigners bought the most stocks and bonds in the September quarter since the three months ending March 2015, as the government took steps to boost growth.

China and the US have considerable business interests in South Asia and any escalation could hurt the economies of both India and Pakistan. The two big powers have urged India and Pakistan not to further escalate the situation along their de-facto border.

Relations between India and Pakistan are often tense and the countries, both of which possess nuclear weapons, have fought three wars since the partition of British India in 1947. India's retaliation came after India's director general of military operations said the army received "credible and specific" information about attacks planned both in Kashmir and major Indian cities.

The move followed weeks of mounting domestic pressure on Mr Modi to punish Pakistan for what New Delhi believes is Islamabad's support for terrorists striking inside India."We are entering the worst period for India-Pakistan relations in over a decade," said Shashank Joshi, a fellow at the Royal United Services Institute in London.

India's announcement of its raid is likely to heighten tensions along the Line of Control, including skirmishes and shelling, Mr Joshi said. But Pakistan's initial response - denying that surgical strikes even took place - suggests recent moves are unlikely to result in all-out war.

Instead, "Pakistan may seek to respond by encouraging or assisting another attack on the Indian army in Kashmir by jihadist groups, or even a terrorist attack in an Indian city," he said, adding that Islamabad's denial "helps Pakistan save face, and so reduces the risk of serious escalation."

Mr Modi's government has been examining further diplomatic responses, though those too are unlikely to have broader economic fallout. India led a boycott of the South Asian Association for Regional Cooperation last week, leading to the November summit's postponement.

Mr Modi is examining a water treaty that governs rivers flowing from India to Pakistan and whether to revoke the "Most Favoured Nation" trading status it granted to Pakistan in 1996 - an act that was not reciprocated.

Worsening ties between Pakistan and its South Asian neighbors will likely push Islamabad even closer to China, according to Eurasia Group's Riser-Kositsky. Beijing is pursuing a US$45 billion investment that traverses parts of Pakistan-controlled Kashmir. But China will also probably push for tensions to be defused.

"It's in China's interest for the region to stay stable and it's impossible for China to take sides at the moment," said Sun Shihai, president of the official Chinese Association for South Asian Studies in Beijing.

"China used to support Pakistan's stance on Kashmir but now it believes the area is a disputed territory and both India and Pakistan need to sort out their problems via peaceful dialogue."

BLOOMBERG