Pakistan remains among Asia’s riskiest investment destinations, with a weak government struggling to contain a deadly domestic insurgency.

Sovereign 5-year credit default swaps are trading at a spread of 750 basis points, down from 875 two months ago but still by far the riskiest component of the Thomson Reuters Emerging Asia Index.

Pakistan’s stock market has more than doubled from lows hit last year during the worst of the global crisis, but few foreign portfolio investors have significant holdings, and local investors are less sensitive to risk.

Following is a summary of key Pakistan risks to watch:

* INTERNAL SECURITY

Large swathes of Pakistan remain outside government control, run by the Taliban and tribal leaders. Last year’s military campaign to roll back Taliban territorial gains saw a number of successes, but insurgents have shown they can launch major attacks in urban, industrial and commercial centres with relative impunity. The U.S. troop surge in Afghanistan could also cause more instability in Pakistan’s border regions.

What to watch:

– Ability of militants to launch attacks. Several assaults on military facilities in particular have shown the continued ability of Taliban militants to attack even protected targets. There is no sign of a sustained improvement in security despite offensives against the Taliban. Pakistan’s markets have long grown accustomed to the level of violence and bomb attacks will not have a significant short-run impact on prices unless key government or military leaders are killed. Investors are more sensitive to attacks in Karachi, the commercial hub and home to the main financial markets, the central bank and the main port, but several recent bomb attacks did not spark heavy selling. However, investment will be deterred by continued instability, with negative implications for longer-term growth.

– Safety of Pakistan’s nuclear arsenal. Pakistan’s poor record of preventing attacks on even secure military targets has raised concern that militants could penetrate a nuclear facility. Analysts say that while there is minimal risk insurgents could get their hands on a nuclear missile, a potential danger is that they could steal some fissile material which could be used to build a “dirty bomb”. This scenario would unsettle markets not just in Pakistan but also in India.

* EXTERNAL SECURITY

Relations with India have improved from the lows hit after the Mumbai attacks in late 2008. The countries’ prime ministers had “very good talks” at a regional summit in Bhutan last month and asked their officials to take steps as soon as possible to normalise relations.

Washington has been trying with some success to persuade Pakistan to focus on the Taliban threat within its borders rather than the perceived external threat from India. But with many groups in Pakistan still sworn to launch more attacks in India, particularly over disputed Kashmir, there is constant risk of another sudden chill in relations. With two nuclear-armed powers facing off, there is also the risk an accident or misunderstanding escalates into major conflict.

The involvement of Pakistani militants in a failed car bomb attack in New York has further embarrassed the government.

What to watch:

– Attacks in India. Any attack with Pakistani fingerprints could spark a serious confrontation, pushing down markets on both sides of the border.

– Progress on talks. India has been reluctant to broaden the agenda to problems such as Kashmir until more is done in Pakistan to deal with those behind the Mumbai attacks. Any sign of rapprochement will be greeted positively by investors, but would not have much impact on short-run market movements.

* GOVERNMENT EFFECTIVENESS

The government has limited control over the military, and has also been undermined by tussles with the judiciary. It has been relatively ineffective in tackling corruption and reforming the economy. President Asif Ali Zardari has signed into law constitutional amendments transferring important powers he held to the prime minister and parliament. This should go some way to disarming his critics. But the government remains weak and prone to splits. Problems in formulating and implementing policy will continue to act as a drag on investment.

What to watch:

– Changes in political balance of power. Markets will be watching manoeuvring by opposition parties and the military to gauge the possibility of a challenge to the government. Most analysts expect the government to remain in power for now, but distracted from reforms because of its focus on survival.

– A December decision by the Supreme Court that a 2007 amnesty decree was unconstitutional has opened some close allies of Zardari to charges, further weakening the government and distracting from policymaking. Zardari, though protected from old charges by presidential immunity, could face legal challenges to his eligibility to be president. Such challenges would likely unnerve investors, not because Zardari is seen as indispensable but because political turmoil would distract the government from efforts to improve security and the economy.

* ECONOMIC REFORM AND INVESTMENT IN INFRASTRUCTURE

Pakistan has traditionally had legislation that favours openness to foreign investment, and given the government’s need to promote growth, there is the chance of more economic reforms. These may not be enough to reverse the impact of chronic insecurity and corruption, however. Investment is desperately needed in infrastructure and energy — power shortages have badly damaged the economy, particularly in Karachi.

What to watch:

– Status of IMF loan disbursements. Earlier this month, the IMF agreed to waive some of its requirements and release a fifth tranche, amounting to $1.13 billion, of a $10.66 billion loan. Pakistan has now drawn about $7.27 billion of the loan. It had asked for a waiver on some of its targets, including the quarterly budget deficit and net government borrowing limits. The IMF says the economy remains highly vulnerable. But given the eagerness of the United States and its allies to ensure Pakistan does not risk implosion, they will probably continue to help bail out the economy when required. (Compiled by Islamabad bureau and Andrew Marshall)