MUMBAI, Jan 6: Thawing relations between India and Pakistan will boost investor sentiment but will have no material impact on capital or trade flows unless backed by concrete steps, business leaders say.

Financial markets in both countries were muted in their reaction on Monday as Indian Prime Minister Atal Behari Vajpayee and Pakistani President Pervez Musharraf met for the first time in two years, on the sidelines of a South Asian summit.

The Karachi Stock Exchange's key 100-share index rose 0.6 per cent and India's 30-issue benchmark Bombay share index edged up 0.21 per cent as Vajpayee and Musharraf pledged to continue efforts to repair relations. The Mumbai market hit a new closing high and extended its gains on Tuesday but dealers said this was driven by local factors and investors were waiting to see whether the meeting would lead to steps to settle the long-pending Kashmir dispute.

"Investors want to see a long-lasting improvement in relations," said Paras Adenwala, head of equity funds at Birla Sun Life Asset Management in Bombay. "But it is too early to think along those lines yet."

The meeting followed steps in recent weeks to re-open road, rail and air links between the two countries - part of a process to reduce tension that analysts hope will lower the political risk profile and eventually boost foreign investment.

"Any breakthrough will reduce investment risks in the region," said Mohammad Sohail, head of research of Investcap Securities in Karachi. "Foreign direct investment is an issue for both countries, especially Pakistan."

India attracted $4.4 billion in foreign direct investments in 2002 - less than a tenth of the $52.7 billion received by economic rival China. Foreign direct investment in Pakistan runs at a comparatively tiny $500 million to $600 million a year.

The talks between the two leaders, the first since a failed summit in 2001, came ahead of the signing at the summit on Tuesday of an agreement to set up a South Asian Free Trade Area. The agreement to reduce or eliminate tariffs by the seven members of the South Asian Association for Regional Cooperation - which includes Sri Lanka, Bangladesh, Nepal, Bhutan and the Maldives - is set to come into force in 2006.

Observers say the agreement could double within two years Pakistan and India's current $1.5 billion annual bilateral trade.-Reuters