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Last week, as Standard & Poor’s revised its India outlook to negative (from stable), credit default swap spreads for State Bank of India and ICICI Bank (NYSE:IBN) rose to levels not witnessed since last November. Today, as Pakistan’s opposition parties start their “long march” to Islamabad, Pakistan’s capital, default risk buyers for both India and Pakistan have retreated altogether. Depending upon how unstable Pakistan looks by the end of the day, sovereign risk perceptions for a number of Asian countries will deteriorate dramatically going into the weekend.

Last June, shortly after Taliban militants burnt down the ski resort of Malam Jabba, in the Karakoram mountain range, an Austrian snow-making expert fleeing Pakistan declared that “Washington needs to understand that the war on terror has reached the heavily populated regions of Pakistan and the focus on the border regions is totally misplaced.” The Malam Jabba ski slopes are in the vicinity of the picturesque Swat Valley, in Pakistan’s North West Frontier Province; the Swat Valley is under the control of Islamic radicals following a “peace deal” with the Pakistan government. Malam Jabba, or whatever is left of it, now serves as a training camp for fighters loyal to Mullah Fazlullah-nicknamed Mullah Radio due to his habit of taking to the airwaves at the slightest opportunity-who runs a fundamentalist outfit banned by Islamabad.

Few knowledgeable observers of the post-9/11 war on terror doubt that increasing instability in Pakistan will not only turn President Obama’s Afghanistan strategy into a non-event. But also at stake is the impact the instability in Pakistan will have on its neighbours (e.g. Afghanistan, Iran, India, Central Asia and Far-Western China) and on countries with powerful Islamist movements (e.g. Egypt, Bangladesh, Indonesia and Somalia). While the Obama Administration is targeting Osama Bin Laden and his Al Qaeda cohorts, the street-level threat from poverty-stricken Muslim neighbourhoods everywhere is increasing with each passing day. “The most immediate area of concern, of course, is India,” a Hong Kong-based CDS price-maker conceded. “I see India default risk widening sharply as traders get a grip on the building crisis in Pakistan.”

Five-year CDS spreads on State Bank of India breached 500 basis points in Asian trading. ICICI Bank is being quoted at 750-800 bps. Both banks are viewed as proxies for India sovereign risk, which is already under pressure from the global credit crunch. Economic analysts in Mumbai and New Delhi were reluctant to go on record with their views on how the conflict in Pakistan could or would influence India in the near-term or medium-term. But the strife-torn province of Punjab has a lengthy border with India, the Swat Valley is less than 600 km from major Indian towns and, perhaps most importantly for both India and the West, heightened political unrest will bring back into play the question of control over Pakistan’s nuclear assets.

By 0400 New York time, the Pakistan government had ordered the arrest of hundreds of opposition activists and lawyers. Thousands of protestors had gathered in Karachi and Quetta to begin the long march to the capital. From an undisclosed location, Pakistan’s legendary cricketer-turned-politician, Imran Khan, warned that “the situation could spin out of control, into a speedy downward spiral, at short notice.” And, as if to complicate matters, those currently directing the protests in numerous locations are hardened members of Pakistan’s oldest Islamist organization, the Jamiat-ul-Islam.

The Indian stock markets were surging in early trading today, but there is every reason to conclude that India-based ETFs and ETNs (EPI, ICN, INP, PIN) remain solid short propositions on any rallies from yesterday’s closing levels. The risks in a short-India trade are very limited indeed, particularly with the uncertainty surrounding the Indian general elections in April and May.

This writer is of the view that the trouble in Pakistan is grounded solidly in the failure of successive Islamabad governments to attack the problems of impoverishment and illiteracy with any commitment whatsoever; so, wherever the long march ultimately ends up, one cannot look forward to anything but chaos in the weeks and months ahead. And the effects of continuing anarchy in Pakistan will certainly be felt beyond India. “As Pakistan goes, so goes the global war on terror, globally,” Mr. Khan told this writer before rushing off to another undisclosed place.

Disclosure: Author holds short positions in IBN, ICN