By Sujata Rao and Peter Apps

LONDON, Dec 28 (Reuters) - Pakistan's brief period as a destination for adventurous investors seems over for now, as the killing of opposition leader Benazir Bhutto brings fresh instability to an already volatile nuclear-armed nation.

Bhutto was assassinated on Thursday ahead of Jan. 8 elections that were seen ushering in democracy after a decade of military rule and promoting policies that -- vitally for investors -- would include a commitment to stamp out Islamist militants in areas bordering Afghanistan.

But hopes now lie in tatters that leading Pakistani politicians can create a bulwark against militant Islam and bring in a stable government allied to the West.

"This is the worst possible scenario for foreign investment. Probably there are many months of volatility ahead and this environment of chaos is perfect for Islamic militants," said Luis Costa, head of emerging debt at Commerzbank in London.

"In the first half of 2007, we saw Pakistani assets outperforming which brought in real money managers," Costa said. "We will probably now see a reversal of this trend."

For the past couple of years, Pakistan has lured growing amounts of foreign cash -- the Karachi stock market <.KSE> is up 50 percent year-to-date, making it Asia's top performing index.

While less than 10 percent of this $70 billion-plus market is so far held by foreigners, flows have been rising especially from the oil-rich Middle East, as the attraction of a fast growing economy outweighed the rising political risks.

Foreign direct investment too has been on the up. It almost doubled in the last fiscal year, while in the first five months of the 2008 July-June fiscal year it rose by almost $500 million to $1.7 billion, according to central bank data.

Part of this is due to President Pervez Musharraf's liberal economic policies and the semblance of stability that his firm military rule brought. Secondly, Pakistan has been lifted by the same tide that buoyed most emerging markets throughout 2006 and 2007.

"So far Musharraf has delivered reasonably well -- the stock market has gone up, investment has gone in and the economy has done OK," said Rashna Writer, principal analyst at The Risk Bureau, a consultancy in London.

"The problem for Pakistan is that its (civil) institutions have been weakened to the point of being feeble," she said, referring to the parliament and judiciary.

FEARS

Bhutto's death has already sparked rioting and deaths and fears are that this will intensify in coming weeks, possibly even pitching the nuclear-armed country into civil war.

Pakistan's share and currency markets, closed for three days, have not yet reflected the shift in sentiment. But foreigners have been hedging their exposure to Pakistan, with the cost of buying five-year protection via credit default swaps rising some 100 basis points since Bhutto's assassination.

The yield on Pakistan's 2017 dollar bond is now almost 600 bps over U.S. Treasuries, compared to 400 bps last week and the 250 bps premium at which it was issued in May.

Rating agency moves will be key, with Standard & Poor's saying that in case of "a period of heightened political instability, (B+) ratings will be lowered."

Elections are to go ahead despite the killing and riots, though ex-prime minister Nawaz Sharif, who was ousted by Musharraf in 1999, has said his party will boycott the vote.

The outcome may be anyone's guess but one thing is clear -- the new leader's job is an unenviable one.

"The demands that Washington is going to put on the leader are going to cause problems because the leader is not going to be able to satisfy Washington and the domestic audience," The Risk Consultancy's Writer said.

"The militants will make it their goal to highlight those problems and tensions, and make them worse."

One result, maybe not unwelcome to foreign and domestic investors in the near term, is that military or emergency rule is reimposed, allowing the new army chief Ashfaq Kayani powers to stamp out militant training camps.

The alternative -- a political vacuum caused by weak government -- could be filled by radical Islamists, many fear.

"One may be right that in the short-term we need a strong hand. Musharraf will probably have more space and international pressure for democracy may ease a bit at least until the civil unrest comes to an end," Costa said.

Many are less gloomy however, suggesting Bhutto's assassination is only one more tragedy in the history of the country that has been buffeted by several wars and coups in its 60-year history that commenced with the partition of India.

Ahsan Chishty, economist at Standard Chartered in Karachi, says all hinges on how effectively order can be restored. The central bank has over $15.6 billion in its coffers to deal with weakness in the rupee -- up from $12.7 billion in January 2007.

Chishty expects $3 billion in FDI in the next six months.

Investors from "the Middle East and China in particular are very resilient," he said. "They have seen Pakistan go through difficult times before and they understand its unique bounceability."

(Additional reporting by Nick Edwards; Editing by Ruth Pitchford)

((London newsroom +44 20 7542 6176 [email protected]; RM: [email protected]))

Keywords: MARKETS PAKISTAN/INSTABILITY