MUMBAI/ISLAMABAD (Reuters) - Share markets in India and Pakistan fell on Thursday after India said it had conducted "surgical strikes" on suspected militants preparing to infiltrate from Pakistan-ruled Kashmir, escalating tensions between the nuclear-armed neighbours.
The Nifty was down 1.8 percent after falling as much 2.1 percent to its lowest since Aug. 29, while Pakistan's benchmark 100-share index was down 0.5 percent after earlier rising as much as 1.3 percent to a record high.
Indian benchmark 10-year bond yields were up 10 basis points to 7.02 percent from its previous close, while the rupee weakened to 66.89/89 from its close of 66.46 on Wednesday.
"Markets will closely watch the next few days for further developments. Any such conflict creates uncertainty in the investment climate," said Shubhada Rao, chief economist at YES Bank in Mumbai. "But it is premature to talk about serious war."
Confusing the picture, the Pakistani military said no such strike had taken place but that there had been an exchange of fire at the frontier in which two Pakistani soldiers were killed.
If India has carried out surgical strikes, inflicting significant casualties, it would represent the first direct military response to an attack on an Indian army base earlier this month that New Delhi blamed on Pakistan.
The announcement by Indian army's head of operations sent India's share market Volatility Index (VIX), often seen as a "fear gauge", up as much as 37.6 percent.
Analysts in both countries, however, expect tensions would eventually ease given the stakes involved even if India has departed from its characteristic stance of strategic restraint.
"The consensus is that it’s not going to lead anything crazy like a war, but it's bad for sentiment," said Gohar Rasool, head of sales for Karachi-based Intermarket Securities.
Prior to the alarm over potential for conflict, investors in India were already growing cautious ahead of a central bank policy review on Tuesday.
Shares had already fallen in three out of the previous four sessions as the Reserve Bank of India is expected to leave interest rates on hold on Tuesday, waiting for more evidence of inflation subsiding.
Although inflation eased to a five-month low of 5.05 percent in August, it remains near the top end of the RBI's 2 to 6 percent inflation target.
(Reporting by Darshana Sankararaman in BENGALURU, Suvashree Dey Choudhury in MUMBAI, and Drazen Jorgic in ISLAMABAD; Writing by Rafael Nam; Editing by Simon Cameron-Moore)