A NATO attack killed 24 Pakistani soldiers on November 26, and in mid-December U.S. lawmakers agreed to freeze $700 million in aid to Pakistan until it gives assurances it is helping fight the spread of homemade bombs in the region.
NATO aircraft struck two military border posts in northwest Pakistan, in the worst incident of its kind since Islamabad allied itself with Washington in 2001 in the war on militancy.
Relations were already strained after claims in late September by Admiral Mike Mullen, the former top U.S. military officer, that Pakistan was supporting militant attacks against Afghan and U.S. targets in Afghanistan.
The attack sparked fury across Pakistan, with Islamabad rejecting U.S. claims that it was an accident, and demanding U.S. personnel vacate a Pakistani airbase associated with the drone campaign on the country's western border region, a known militant base.
Pakistan has closed its borders to trucks carrying supplies through Pakistan to NATO forces in Afghanistan, and it pulled out of an international conference in Germany on the future of Afghanistan, depriving the talks of a key player which could nudge Taliban militants into a peace process as NATO combat troops prepare to leave Afghanistan by the end of 2014.
Adding to the uncertainty, Pakistan's President Asif Ali Zardari flew to Dubai on December 6 for medical treatment, sparking speculation of that he may resign, which his office has denied.
The domestic political instability and the tense relations with Washington, especially since the killing of Osama bin Laden by U.S. special forces in May, make the overall environment extremely hostile to foreign investors.
Such is the uncertainty surrounding Pakistan's commitment to the U.S-led war on militancy that Congress has suspended $800 million in military assistance to Pakistan.
RATINGS (Unchanged from November unless stated):
MOODY's: B3
S&P: B-
Here is a summary of key risks to watch in Pakistan:
WORSENING RELATIONS WITH AMERICA
The move to freeze $700 million in American aid, and the NATO strike came after a year of crises between the two uneasy allies. Washington has long pushed for action, military or otherwise, against the Haqqani militant network, one of NATO's deadliest foes in Afghanistan and thought to largely operate from North Waziristan.
Islamabad repeatedly said it would not do so, saying its forces were overstretched and it could not afford to provoke a general tribal uprising.
Reflecting American frustration with Pakistan, and suspicion that there are links between Pakistan's powerful spy agency and militants operating in Pakistan and Afghanistan, there have been many proposals to make U.S. aid conditional on more cooperation in fighting militants such as the Haqqani network Washington believes operates out of Pakistan and battles U.S. troops in Afghanistan.
Though the cutback announced is only a small proportion of the billions in civil and military assistance it gets each year, it is a warning sign that Washington is losing patience with Islamabad, and that relations may worsen. What to watch:
-- A further attack or unilateral raid on Pakistan from NATO forces in Afghanistan. Another attack could conceivably break the alliance completely, putting the war effort in Afghanistan at risk.
-- More aid cuts. December's move could presage greater cuts as calls grow in the United States to penalize Islamabad for failing to act against militant groups and, at worst, helping them.
-- Any further accusations from Washington, how Islamabad responds, and the tone of the rhetoric from both sides. The United States wants Pakistan to bring the Haqqani network into peace negotiations, but is wary of exerting too much pressure on Pakistan and forcing a break in ties.
INTERNAL SECURITY
There has been a noticeable decrease in bomb attacks in Pakistan, but random violence continues to affect parts of the southern port city of Karachi, Pakistan's key financial hub.
More than 1,600 people have been killed in the city this year, over half of them in political and sectarian violence, and Pakistan's paramilitary forces have been deployed in the southern port city to try to stabilize violent districts.
The violence and instability are a huge deterrent to foreign investment. Investors are particularly sensitive to attacks in Karachi, home to key financial markets and the central bank.
Sunni militants have stepped up attacks against Shi'ites in Baluchistan in recent months. On September 20, gunmen in the province opened fire on a bus, killing 26 Shi'ite pilgrims travelling to Iran. Ethnic Baluch militants have been waging a low-level insurgency in Baluchistan for years for more autonomy and greater control over natural resources of the region.
What to watch: -- Further attacks by militants. The assaults on high-profile military facilities have shown the continued ability of Taliban fighters to attack even protected targets.
-- Talks with the Taliban? The deputy commander of the Pakistan Taliban said in December his group was in talks with the government, which the prime minister and interior minister then denied.
POLITICAL VIOLENCE, GOVERNMENT WEAKNESS
President Zardari's treatment in Dubai for what could be a minor heart attack has sparked rumors that he may resign.
While the government maintains that the treatment is routine, the episode is indicative of the level of mistrust and suspicion that surrounds the president, and the continued belief the Pakistani army can and will take control -- or at least exert influence -- as it sees fit. Political leaders, many of whom are seen as incompetent and corrupt, have offered little guidance. Zardari's government is weak, prone to splits, has limited control over the military and has failed to tackle corruption or reform the economy. Serious problems formulating and implementing policy will continue to deter investment.
Pakistan's cash-strapped government has also been slow to respond to fresh flooding in the southern province of Sindh, which has killed over 300 people and damaged or destroyed about 1.4 million houses.
What to watch:
-- Attacks on politicians, and alliances forming between Islamist parties to challenge the government.
-- Any move by the military to more openly influence political developments.
EXTERNAL SECURITY
Relations between Afghanistan and Pakistan have faltered, with cross-border attacks reported by both sides.
Tension between the neighbors has been heightened by whispering from some Afghan lawmakers that Pakistan's spy agency, the Inter-services Intelligence (ISI), was behind recent assassinations in Afghanistan, something Pakistan vehemently denied.
Pakistan is a critical regional stakeholder, and backing out of the Bonn conference sends the message that it has lost faith in international efforts in Afghanistan and wants to pursue its own interests -- possibly at the expense of the West.
Relations with Afghanistan look increasingly fragile as a result of both Pakistan's absence at Bonn, and a series of attacks in Afghanistan that Afghan President Hamid Karzai has said were tied to Pakistan.
Karzai said Pakistan-based militant group Lashkar-e-Jhangvi claimed responsibility for the bomb attacks in Afghanistan on December 6 that killed 59 Shi'ite worshippers.
He has also said the assassination of former Afghan president Burhanuddin Rabbani, who was charged with leading peace talks with the Taliban insurgency, was planned in Pakistan.
Relations with India have also been shaken by the killing of bin Laden, with some Indian commentators questioning Pakistan's ability and will to contain militant activity.
What to watch:
-- Drone attacks. Any drone attack that results in high civilian deaths could further damage the U.S.-Pakistan relationship.
-- Attacks in India. An attack with Pakistani fingerprints could spark serious confrontation.
ECONOMIC REFORM AND INFRASTRUCTURE
Pakistan's cabinet unanimously decided on November 2 to grant India Most Favoured Nation (MFN) status, a major breakthrough that could bolster efforts to improve relations between the nuclear-armed rivals.
There are hopes that progress in trade ties will help bolster a fragile peace process, which the two resumed in February, with political implications likely to outweigh any practical benefits.
The two countries' commerce ministries say trade could easily triple in three years, which could help shore up Pakistan's rickety economy.
The Pakistani rupee has continued to drop against the dollar, recently hitting repeated lows, and the country's economy is propped up by an $11 billion loan program from the International Monetary Fund (IMF), as well as aid from donors including the United States.
Pakistan has said it will not seek a new loan program or an extension to the loan, because it had no immediate balance of payments crisis, a move analysts say is a risk.
Pakistan's economy is still highly vulnerable to widening deficits, and bold moves based on false optimism could possibly lead to a downgrade from ratings agencies.
What to watch:
-- The level of donations for flood relief. Paltry donations could signal that donors are losing patience with Pakistan on many issues.
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