SCENARIOS: Potential outcomes in Pakistan's war with Taliban

ISLAMABAD (Reuters) - Pakistan's military is pressing ahead with an offensive to try to crush the Taliban, following warnings from Washington that the militants pose an existential threat. Following are some scenarios of how events could unfold:

WEAK PAKISTANI GOVERNMENT STRUGGLES TO PUSH BACK TALIBAN

Even if Taliban fighters melt away from their strongholds in Swat in the face of the latest army offensive, they can regroup. Militants could stealthily widen and consolidate their territorial grip as long as they were careful not to overreach and provoke another major army offensive.

"The Pakistan Taliban are effectively taking advantage of the lack of governance and development. Neither appeasement nor military assault is likely to prove effective for handling the long-term threat posed by these groups," said Maria Kuusisto, Pakistan analyst at Eurasia Group in London.

The outlook would be more of the same -- instability, a continued terrorist threat, and a divided Pakistani leadership. But this relatively negative outlook is already priced in, analysts say, meaning local markets will largely ignore the poor security situation and focus on the brighter economic picture. There would be room for gains by local stocks, and the rupee would stabilize, seeing an orderly depreciation over time due to exchange rate reforms. There would be little or no impact on global markets.

MILITARY OFFENSIVE DEALS SIGNIFICANT BLOW TO TALIBAN

The Pakistani government and army so far retain considerable public support for their offensive against the Taliban in Swat. If they can press home their advantage and deal a significant military blow to the Taliban, stocks could see strong gains.

"We reiterate that investors keep an eye on the bigger picture and any progress on the political and military front should be taken as a bullish signal," Credit Suisse said last week. Analysts said the stock market upside could be 25 percent.
The military has also shown success in dealing with militants in tribal areas earlier this year. But crushing an insurgency is notoriously difficult.

"Pakistani military forces already are privately expressing their concerns that many of the Taliban have blended in with the refugees fleeing the district, likely making it a matter of time before Taliban forces are able to reconstitute themselves in the area," risk consultancy Stratfor said in an analysis.
Furthermore, a sustained campaign against the Taliban would worsen an already severe refugee crisis and send the civilian death toll sharply higher, undermining popular support. "If the war against militants becomes a prolonged one, and with heavy civilian casualties (as can be expected), public resentments against the government may well serve to break up the unity, laying the groundwork for both social and political unrest," said Jan Zalewski, analyst at IHS Global Insight.

TALIBAN MAKES DRAMATIC TERRITORIAL GAINS

If the Taliban was able to make significant inroads into the key provinces of Punjab and Sindh, the implications would be highly bearish for local stocks and the rupee, and global markets could be rattled by the rising risk that Pakistan could implode. But the chances of this happening are minimal.

The Taliban remains a loose coalition of disparate militia groups, able to muster at most up to 10,000 fighters who are expert at insurgency warfare in their tribal strongholds but would be quickly crushed in a conventional war with the army. Their popular support in Punjab and Sindh is minimal.

"We may see pockets of Talibanization -- parts of Karachi are vulnerable," said Chietigj Bajpaee at Control Risks. "But the whole country falling under Taliban rule is an exaggeration."

MILITARY TAKES POWER AGAIN

Given the increased popular resentment that forced former President Pervez Musharraf to relinquish power, analysts say the Pakistani military has little appetite for another coup. But if the situation deteriorates badly, that could change.

"Over the six months or a year, another military intervention is unlikely, given the backlash against the Musharraf government," Bajpaee said. "But if there is seen to be significant political gridlock, and the government is not seen to be taking action, then there is a possibility."

Analysts say that given the unpopularity of President Asif Ali Zardari, a coup would be positive for markets. "Given Pakistan's unfortunate history of coups, it would be a very unwise person indeed whoever ruled out a coup in Pakistan," said Nomura senior political analyst Alastair Newton. "But I don't see that as a bad thing in terms of market perceptions."

STRONGER GOVERNMENT EMERGES

Zardari's approval ratings have tanked and opposition leader Nawaz Sharif enjoys far higher popularity -- a poll this week gave him 75 percent approval versus Zardari's 19 percent.

Sharif appeals to a religious conservative constituency, and was a "bete noire for Washington" in the past, Newton said. But there are signs that the United States, exasperated by Zardari, is starting to make overtures to Sharif.
Analysts say that if a way can be found to bring Sharif and his supporters back into the government fold, either through an accommodation with Zardari or by removing him probably with the army's help, this would be positive for stability and markets.
(Editing by Sugita Katyal)

(Reuters)