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Archive for February, 2008

Pakistan Events Drive Increasing South Asia Regional Risk – India to be Affected

Monday, February 11th, 2008

Conditions in Pakistan are increasing regional risk in South Asia. India country-risk is up, and the South Asian regional security outlook has shifted distinctly for the worse as a result of recent events in Pakistan and the Pakistan-Afghan borderlands. While the press has focused on Benazir Bhutto’s assassination, significant military and public health events (bird flu outbreak in West Bengal) in the region are also exacerbating South Asia regional instability and insecurity.

Medium-term, this heightened risk profile of the region likely outweighs potential benefits of the recent US Federal Reserve interest rate cuts to the Indian securities markets.

Longer term, the result of Benazir’s death in particular, as discussed below, may lead to some surprising outcomes. Rather than drawing the US and India closer, the assassination and related rising Islamic militancy may lead to a cooling in Indo-American relations.

Key Issues:

1) Political-military dynamics in the region changed for the worse in the month between December 26th, 2007 and January 26th, 2008. Though the January 26th Pakistani missile test is not a complete surprise, it adds significant tension to an already-volatile environment. The negative tone and trend set by Benazir Bhutto’s assassination has been followed by a rise in violence such as organized attacks on the Pakistani military and bombings targeting urban civilians and Pakistani officials.

2) With the dramatic shift in the South Asian regional security outlook, India’s country risk is notably up. Will there be outside-actor involvement in the region? What may be the potential impact of Hindu-Nationalist bellicosity in the Indian press and parliament? The Congress-led domestic political coalition in India is now under pressure from the increased regional insecurity and from the domestic political competition for 2008 state-level elections (and possibly mid-term general election polls) or from a projected general election by early 2009. Will there be a softening of partnership ties within and around?

3) The regional risk profile of South Asia will be challenged by uncontrolled events in Pakistan in 2008. Will Benazir’s assassination surprisingly lead to cooling of Indo-US relations?

4) Mounting South Asian regional risk is likely to outweigh the beneficial effect for Indian securities markets of recent US Federal Reserve rate cuts. Cooling Indo-US relations could diminish prospects for US direct investment in India at the margin.

Punctuating Event, Volatile Environment

In October of last year, I forecast that a single punctuating event could dramatically change the risk profile of South Asia.

Benazir’s assassination is such an event. In South Asia, regional instability is both the cause and consequence of Benazir’s assassination. What are the signs of this regional instability?

Missile Tests

The January 26 Pakistani test of an intermediate-range ballistic missile is yet another distinct step in escalating South Asian tension. The missile (known both as the Shaheen I or Hatf IV) is capable of carrying a nuclear payload well into India. This follows the Pakistani cruise-style missile test in December 2007.

Pakistan’s January 26th missile test comes within weeks of an announcement from India’s Defense Research and Development Organization that the Ministry of Defense would seek to deploy an anti-missile system within three years.

Headlines in the world press about ballistic missiles above South Asia may well have a chilling effect on investment in the region.

Notably, this test took place while Pervez Musharraf was abroad. Statements on the test were aired by the new Army Chief-of-Staff Ashfaq Kayani. Some believe the test and Kayani’s comments were intended to assure outsiders of the integrity of a reliable military chain-of-command autonomous from the now-nominally-civilian Musharraf. The security of Pakistan’s missile and nuclear weapons has been a growing matter of concern since the Fall of 2007. On the contrary, the test’s timing will not ease tensions, raising as it does the specter of a regional arms race, the threat of loose nuclear weapons, and the danger of a resurgent regional rivalry.

Spreading Violence

Bhutto’s assassination is both cause and consequence of a general increase in violence in Pakistan. The assassination has been followed by more suicide bombings targeting new types of targets. The January 10th suicide bombing in the city of Lahore, for instance, is a punctuating escalation, showing that the violence is spreading east into the province of Punjab, the country’s middle-class heartland of commerce and agriculture. Punjab also happens to be the main recruiting zone for the Pakistani army.

American defense planners seem to be paying attention. In Senate testimony on February 6th, US intelligence officials suggested that Pakistan might be “facing an existential crisis due to a spike in deadly terrorist attacks over the past year.”

Also, while most Pakistanis are moderate, new informa
tion available at the beginning of 2008 suggests that the growth of extremism and the nature of its appeal in Pakistan are poorly understood, but probably also underestimated. Nicholas Schmidle was thrown out of Pakistan after his January, 2008 New York Times Magazine article “Next-Gen Taliban appeared. His eviction, at least in part, signaled that reporting on the Shariah-oriented-states-within-a-state (such as the one he witnessed in the Swat Valley) is entirely unwelcome. Other reporting in The New York Times asserted that the old ISI state-within-a-state has lost control of its extremist agents. And Steve Coll of the New Yorker, a long-time South Asia hand, worried in late January that Pakistan was “unraveling”. His sources in the US defense community told him that US military planners had finally realized that the Northern and Western areas of Pakistan “were not suddenly going to become governable.”

Eastern Theatre Upgrade: Prominence of a South Asian “Zone of Conflict” Grows in 2008

In 2007 events in Iraq far overshadowed those in South Asia. They may continue to do so in 2008. But, in the coming year, South Asia will grow in prominence both for the US and for violent Islamist terror groups. From Afghanistan in the North West to the Iranian borderlands with Pakistan’s restive Baluchistan province in the South West, from the Indo-Pakistani border near Lahore and further north to Kashmir in the North East, a new zone of conflict may well coalesce in the minds of American and NATO political-military planners and in the minds and operations of their terrorist opponents. It is not clear how India and China will respond. But I would be surprised if the BJP in India is not tempted to take advantage of the political opportunities this would present.

In late January, 2008, three different high-powered reports concurred on the growing possibility of a “failed state” outcome in Afghanistan. This increases the importance of focusing on the “zone of conflict” in the Northwest region of South Asia mentioned above. I have for three years been arguing that Afghanistan and Pakistan must be treated as a single problem and that analysis and policy-making must not be distracted by the existence of a nominal international boundary between the two states. In the coming year, Selig Harrison’s warning that recent events are putting Pakistan’s multi-ethnic state under stress will gain attention, and I would add that Pakistan has not faced such stress since the prelude to the 1971 division of the country when Bangladesh seceded. Harrison’s argument suggests that the “zone of conflict” may spread from Afghanistan and Pakistan’s Waziristan-and-tribal belt to Sindh and Baluchistan, rendering the nominally viable state of “Pakistan” what he calls a “Punjabi rump state and its army.”

US-Pakistan relations are already being transformed by these troubling possibilities. Evidence of concern emerged in January, 2008 when both US Defense Secretary Robert Gates and chief of US Central Command, Admiral William Fallon openly discussed the possibility of a greater US military role in Pakistan. In November 2007, The New York Times editorial committee considered it reasonable to publish an op-ed discussing an American use of force to secure that country’s nuclear weapons. Chairman of the Joint Chiefs Adm. Michael Mullen’s departure for Pakistan on February 7th is further confirmation of the concern among US strategic planners regarding the zone of conflict in this northwest region of South Asia. Meanwhile, Pakistan’s economy began to slow in late 2007 and early 2008 – another ominous development that compounds the likelihood of trouble as rising expectations are foiled.

Pakistani Elections and Increasing South Asian Regional Instability

I have been consistently in the minority in questioning the salutary effect of early Pakistani elections under current conditions. Bhutto’s tragic death was shocking but not unforeseen. Any election now will (as I predicted last summer) do two things that will likely make the situation in Pakistan worse before it gets better.

First, an election will enhance the role of Islamist parties in Pakistan. This is because the two key actors left standing by Bhutto’s death – former Prime Minister Nawaz Sharif’s Pakistan Muslim League (N) and Musharraf’s PML (Q) – are both more beholden to Islamists than was Bhutto’s PPP. Bhutto’s death creates a near certainty that any Legislative Assembly elected in 2008 will have a much hi
gher percentage of members from Islamic parties than was the case before the 2002 elections. It is now possible that Islamic parties (even in informal collaboration with the PML parties) could improve their share of the vote (above the historical pre-2002 three-percent level) to ten percent or more.

Second, a stable government was not likely to emerge from legislative elections in Pakistan – even with Benazir’s participation. Informed observers such as Ahmed Rashid have already questioned the likelihood of Musharraf allowing elections to proceed as scheduled on February 18th date. Few will be surprised if they are delayed. Delayed or not, it is a near certainty that the elections will produce an unstable elected government with a cabinet that will surprise many in Washington. It may be one whose legitimacy is in doubt (if Musharraf and the ISI again manipulate the vote as they did in 2002). It may be a coalition of convenience between Benazir’s PPP and former Pakistani Premier Nawaz Sharif’s PML (N). Other permutations are certainly possible. None of these possible governments are likely to be decisive or to play a stabilizing role in the society and polity. An inconclusive and unstable outcome may in fact open up yet greater space for extreme groups exacerbating the previously-mentioned instability and radicalization.

One turn of events that is now increasingly probable and that could have a beneficial effect on Pakistani and regional conditions is that Musharraf may be forced to step aside, relinquishing his post as the President. This is likely to be done under the tacit but intentionally-obvious blessing of the new Army Chief-of-Staff Ashfaq Kayani. It is doubtful, however, that this will happen before the legislative elections, whether they take place as scheduled or not, and consequently, post-Musharraf maneuvering will coincide with the jockeying among political parties that would follow the inconclusive polling. The positive effect of Musharraf’s departure would be diminished if all this political dynamism further emboldens extremists within and outside the formal Pakistani political system; it will also benefit extremists outside the country. If such political disruption unfolds and continues into late May and early June, there is then a good chance that Pakistani domestic instability will be amplified by cross-border tension with India as melting Himalayan snows open passage for militants into Kashmir. That could happen at the same time Taliban forces – enriched by heroin sales from a recent bumper poppy crop – launch their attacks in Afghanistan and the tribal areas of Pakistan.

Democratization Double-talk

Many in the US Democratic Party and other critics of the Bush administration’s failures in Iraq have leveled their critiques at the overly ambitious hopes Bush and his neo-conservative partisans had for democracy in Iraq. Almost all criticism of the US effort in Iraq includes some discussion of how difficult it is to build democratic institutions. Bush’s opponents lament how naïve Bush and his supporters were in their belief that democracy would soon make Iraq a stable and responsible actor in the Middle East.

When it comes to Pakistan, many of the same critics seem to forget their own reservations regarding ill-advised reliance on democratization in Iraq. To be sure, Pakistan is different than Iraq, and there are some democratic precedents in the former British colony. Bush’s naïveté may be nearly matched by the naïve nostalgia of Pakistan democracy advocates.

That nostalgia obscures the many ways in which Pakistani democracy has been problematic. The polity is still largely dominated by the army and the twenty-plus “feudal” families who dominate Pakistan’s rural plains and its party politics. The populism of Pakistan’s first major democratic leader in the 1970s, Zulfiqar Bhutto, initiated Pakistan’s nuclear weapons program. Bhutto, the father, was, by all reports, a coercive bully, despite his popularity. In the last democratic interregnum between 1988 and 1999, Prime Ministers Benazir Bhutto and Nawaz Sharif both presided over political systems that many informed observers believe expanded corruption and failed to improve public services and economic welfare in the country. Moreover, it was Nawaz who followed military dictator Zia’s lead in expanding Islamist Shariah law and in reaching out to, and empowering, non-secular, Islamic parties in Pakistan. Benazir Bhutto blessed the intelligence services’ support of the Taliban.

In the long run, of course, democratic institutions in Pakistan would be a stabilizing and welfare-enhancing force. In the short run, a swift return to competitive democracy in Pakistan is less likely to increase stability and security than would a military dictatorship or an interim “unity government.”

Stepping Back from “Democracy” Promotion, Settling for “Stability” Promotion

From late summer 2007 until the day of Benazir’s December death, US foreign policy spokespersons and officials used the word “democracy” as much as possible in association with Pakistan. We will now hear them use the word “stability” early and often when speaking of both of Pakistan and South Asia.

Markets, however, may instead hear the word “instability”.

Over the next f
our months expect to see more headlines in the global press linking the words “conflict” and “instability” with “South Asia.” If that persists (past May 15th), global investors will realize that India is in South Asia.

Impact on India: Regional Tension May Now Seep Into Indian Domestic Politics

In October 2007, I forecast that a punctuating event could lead to border deployments of regular army and increased naval activity near the Straights of Hormuz. They may now be coming. Look for the following in the next two months: deceleration in Sino-Indian rapprochement; increasing Pak-Afghan tensions; and the greater involvement of extra-regional actors – specifically China, Saudi Arabia, Iran and, most ominously, Afghanistan-based actors newly enriched by the recent spike in opium production.

Also pay attention to two matters in Indian domestic politics: First, bellicose talk from the Hindu Nationalist Bharatya Janata Party in the press and in the coming Budget Session of Parliament may force the ruling Congress-led coalition government to make publicly-detectable changes in border (and naval) deployments from the coast to the Himalayan crest. BJP Party President Rajnath Singh has already begun airing some of the coded speech his party usually leads with before escalating to more overt language. In a recent speech Rajnath referred to the current UPA government’s “failure to keep jihadis in check” and the UPA’s repeal of India’s Patriot-Act-like Prevention of Terror Act (POTA). Second, look for a possible further weakening in the Congress-led domestic coalition. That coalition already faces pressure from “Left Parties” who support the government from outside the Cabinet. Those parties are unhappy with the Indo-US nuclear deal and with certain economic reform initiatives. Recent events may further soften internal support from some parties within the leading coalition such as the Nationalist Congress Party led by Maharashtra-based Sharad Pawar.

January, 2008 saw high profile jockeying among major domestic parties positioning themselves for possible mid-term elections or for a drawn-out campaign season through 2008 in advance of the scheduled 2009 general elections. The drawn-out campaign and the related populist stumping are likely in any case because there are ten state-level-legislature elections scheduled for 2008. The BJP has begun the process of marketing L.K. Advani as its candidate for the Premiership. Similarly, Mayawati of the low-caste-oriented Bahujan Samaj Party has already begun efforts to spread the geographic scope of her party, and begun unofficial-but-open talk of her candidacy for the Premiership in the event of a hung or closely-divided post-election parliament.

Indian Near-Term Growth Assured, but not Medium-Term Growth

Even with a US recession, a growth-rate of over eight percent is nearly assured for India in 2008. However, some combination of factors including bad monsoons, political tangles in Delhi, an appreciating Rupee, increasing inflation, slippage on deficit control, or slowing IT-service exports could jeopardize Indian growth beginning in late 2008. Forecasts from UBS Bank and others have already revised down their late 2008 growth estimates to just above eight percent. Early official reports from the Government of India confirm the likely slowing, and further downward revisions for 2009 would be no surprise.

The size and diversity of India’s domestic economy and the scope of foreign and domestic investment are all still vulnerable to political distraction in Delhi and from panic among foreign investors. Between the situation in Pakistan and the Indo-US nuclear deal, economic issues will receive diminished attention in the 2008 Budget Session of Parliament (February to May). This means that the momentum on economic and regulatory policy will favor the status quo or, at best, temporary administrative measures (at which the current Prime Minister and Finance Minister are masterful). Deeper reform will be unlikely. As this may be the last budget of the current diarchy of the Manmohan-Sonia-directed Congress-led coalition, we are likely to see pre-election populist measures in that document.

Impact of Rupee Appreciation

The delicate balance of current- and near-term global macroeconomic forces at the end of 2007 left Indian country-conditions poised at an indeterminate point. Rupee appreciation has two key medium-term downsides. First, it severely affects software and IT/BPO/KPO firms’ revenues. It also retards the broader transition to export-led growth in India. That transition is urgently-needed to absorb the underemployed, to provide political cover for labor market reform, and to provide hope to the youth bulge now entering India’s economy.

At the end of January, 2008, India’s Reserve Bank stood pat on interest rates and bank reserve ratios. In not easing its monetary stance, the RBI is looking off a chance to slow Rupee appreciation and slow capital inflows. If global investors don’t pull back, this move may be passing the buck (both metaphorically and literally) to the Finance Ministry which may be obliged to devise measures for managing inflows that could otherwise cause inflation and other difficulties. Its not clear how much more sterilization of inflows the RBI can afford and the bond markets can absorb.

US Fed Cuts and the Indian Macroeconomic Outlook

Recent US Federal Reserve interest rate reductions cut two ways for India. They put further upward pressure on the Rupee. They also attract more investment to India. (The US interest rate trend is one of three very good predictors of direct and portfolio flows into India. The other two variables are the South Asia regional security environment and stabi
lity in India’s coalition party politics.)

At such an indeterminate point, last week’s US Federal Reserve Rate cut would probably have tipped the balance in favor of Indian equity markets. However, to Benazir’s assassination has now been added the Pakistani missile test and the above-mentioned increasing prospect of Afghanistan and Pakistan becoming a more serious problem (relative to Iraq) than was the case in 2007. Recent securities market volatility around the world, particularly in India, suggests that the weight of uncertain and violent events in the South Asia region is now possibly overwhelming the effects of the Fed’s looser stance.

Short-term Concern?

If, in coming months, one observes the above indicators in domestic, regional and international affairs in the aftermath of Benazir’s death, one would probably wish to reassess the quality of short-to-medium-term investment returns in India. In the days after Bhutto’s death, Bombay’s exchanges did not show any severe negative reaction. This should not be taken as a sign that foreign and domestic investors in Indian securities have an iron stomach for regional security difficulties. Look for Foreign Institutional Investors (FIIs) to retrench ahead of the Finance Minister’s Budget Speech to Parliament in late February, and keep in mind that India’s securities markets are led by FII trends.

Long-term Concern? Subtle Shifts in Indo-US Relations

Aside from the narrative fascination, the actual identity and motivation of Benazir’s assassins may not matter all that much. In India (and the rest of the world) the dramatic killing of a female democratic and Western-oriented figure like Bhutto will be read as a widening (and escalation) of radical Islamic violence toward the Indian frontier. The idea that a “zone of conflict” between the US and radical Islam now extends from the Turkish border in the West to Pakistan in the East will gain credence among the Indian elite and popular citizenry. As a result, Bhutto’s death will further provoke the ongoing debate in India over the core commitments of that country’s Grand Strategy. Simply put, should India be an American ally? Or will such allegiance only invite more unwelcome radical Islamist attention? Consistent with my “equipoise thesis” on Indian Grand Strategy, I expect a Congress-led Indian government to shift subtly toward a more balanced engagement with other major powers, politely discouraging American entreaties for greater intimacy.

Evidence of this trend includes recent Indian interaction with France, a more-US-neutral Gordon Brown of the UK as well as with China (including military exercises and the Indian PM’s recent Beijing visit). This shift may have commercially significant consequences for the Indo-US nuclear deal and for the associated (and commercially much more significant) Indo-American cooperation and trade in high technology.