India, Pakistan Trade Heavy Fire As Tensions Mount

NEW DELHI (Reuters) - Indian and Pakistani forces traded heavy fire across their frontier for a fourth day on Monday, fanning fears that escalating tensions between the nuclear-capable neighbours could push them into war.

Financial markets in both countries were hammered by war nerves, but despite signs India was preparing for conflict, most analysts said New Delhi was likely to exhaust all diplomatic channels before taking any military action.

Analysts also said Washington, which relies on Pakistan as a vital ally in its war on terror and has U.S. troops there, would pile pressure on both sides to act with restraint.

An Indian defence official said heavy machineguns and mortars were used against Pakistani positions in Monday's fighting. A Pakistani official said 10 villagers had been killed since the latest firing erupted four days ago while Indian officials said four had died.

Nearly a million men have been mobilised by Pakistan and India on their border since a December raid on the Indian parliament that New Delhi blamed on Pakistan-based rebels.

New Delhi says Islamic guerrillas fighting its rule in Jammu and Kashmir are operating freely from Pakistan -- a charge Islamabad denies.

Pakistan's Foreign Ministry spokesman Aziz Ahmed Khan said Islamabad was ready to allow the presence of independent observers in Pakistani Kashmir to confirm militants were not infiltrating into Indian Kashmir.

But the proposal was swiftly rejected by India. "The figures of infiltration have gone up," said Indian foreign ministry spokeswoman Nirupama Rao. "There's no point in seeking to deflect attention by talking of involving third parties."

Khan also reiterated that "all outstanding issues between Pakistan and India should be resolved through dialogue".

India has refused talks until it says it sees proof Pakistani President Pervez Musharraf has honoured a pledge made in January to crack down on Islamic extremists targeting India.

Fears of a large-scale conflict grew after a raid on an Indian army camp last week that India blamed on Pakistan-based guerrillas battling its rule in Muslim-majority Jammu and Kashmir where a separatist revolt has raged for 12 years.

Some 34 people, many of them children and wives of Indian soldiers serving on the front lines, were killed along with the three assailants, in last Tuesday's attack.

Prime Minister Atal Behari Vajpayee was due to visit Kashmir on Tuesday to inspect the scene of the attack and talk to survivors.

BATTLE READINESS

India on Sunday streamlined its armed forces command by putting paramilitary border forces under army control. Military experts said it showed a preparedness for war.

The move followed India's expulsion of Pakistan's ambassador in protest against the raid that Islamabad has condemned.

As part of a diplomatic drive, Indian defence officials were to brief their U.S. counterparts in Washington on Monday. "What's happening on the border... the entire gamut will come up," a defence spokesman said.

Last week, the United States gave strong signals it would soon send Deputy Secretary of State Richard Armitage to the region to try to cool the tension.

U.S. officials fear a conflict between India and Pakistan could disrupt its drive to hunt down members of Osama bin Laden's al Qaeda network and endanger U.S. troops stationed in Pakistan.

U.S. PRESENCE A DETERRENT

"The U.S. presence in Pakistan is one of the deterrents to India exercising the military option," foreign analyst K.K. Katyal said. "An armed conflict between India and Pakistan would (also) come in the way of America's crusade against terrorism."

Peter Duncan, who teaches at University College London, added Washington would likely push Moscow to tell India to show restraint when U.S. President George Bush meets Russian President Vladimir Putin this week in Moscow.

Moscow, a former Cold War ally of New Delhi, was believed to have a lot of influence because it was a principal arms supplier to India.

As war worries mounted, Vajpayee met opposition leaders to discuss the next move of his government led by his Bharatiya Janata Party (BJP).

He has faced pressure from hawkish BJP members for a strike on some of the dozens of militant training camps that Indian officials say have sprung up recently in Pakistani Kashmir.

But A.B. Bardhan, a leader of the Communist Party of India, said he told Vajpayee war could not solve the problem.

The war fears pummelled markets with Indian shares ending near five-month lows, the rupee hitting close to its lifetime bottom against the dollar while government bond yields finished just under five-month highs. Pakistan stocks tumbled over seven percent to end at a 14-week low.

Global rating agency Standard & Poor's warned the sovereign ratings of both nations could be hurt if the tensions persisted.

(Additional reporting by Sugita Katyal and Hari Ramachandran in NEW DELHI and Ashok Pahalwan in JAMMU, India)