UPDATE 2-Pakistan will not tolerate incursions - Zardari

(Adds comment, detail, background)

By Zeeshan Haider

ISLAMABAD, Sept 20 (Reuters) - Pakistan will not tolerate infringement of its territory in the name of the fight against militancy while the biggest challenge facing the government is the economy, President Asif Ali Zardari said on Saturday.

Zardari, the widower of former prime minister Benazir Bhutto, also said in his first address to a joint sitting of parliament Pakistan needed peace with its neighbours and relations with old rival India should be "creatively reinvented".

Zardari won a presidential election this month to replace firm U.S. ally Pervez Musharraf who stepped down in August under threat of impeachment.

Zardari is close to the United States and had earlier vowed to maintain nuclear-armed Pakistan's commitment to the U.S.-led campaign against militancy, even though it is deeply unpopular.

The United States and Afghanistan say al Qaeda and Taliban militants operate out of sanctuaries in remote ethnic Pashtun lands on the Pakistani side of the Afghan border.

Frustrated by an intensifying Taliban insurgency in Afghanistan, the United States has stepped up attacks on militants in Pakistan with six missile attacks by pilotless drones and a helicopter-borne ground assault this month.

The U.S. attacks have infuriated many in Pakistan, which is also battling militants, and the army has vowed to stand up to aggression across the border.

But a senior Pakistani official told Reuters earlier the latest missile strike, which killed five militants on Wednesday, was the result of better U.S.-Pakistani intelligence sharing.

Zardari did not refer to the U.S. strikes but said territorial violations were unacceptable.

"We will not tolerate the violation of our sovereignty and territorial integrity by any power in the name of combating terrorism," Zardari told parliament.

ECONOMIC CHALLENGE

At the same time, Pakistan must stop militants from using its territory for attacks on other countries, he said.

India accuses Pakistan of arming, abetting and sending insurgents across the border into Indian-controlled Kashmir, where militants have been fighting security forces since 1989.

Pakistan says it only offers political support to what it calls a legitimate freedom struggle in Indian Kashmir.

"We must root out terrorism and extremism," Zardari said while highlighting a strategy of making peace with those who renounce violence, economic development and using force as a last resort.

Zardari said the biggest challenge for the government, which is led by his party, was the economy. The most urgent task was food security for the poor burdened by rising prices, he said, but added that would not be enough.

Acting finance minister Naveed Qamar unveiled a package on Friday that included eliminating fuel subsidies, cut its development budget, more privatisation and slashing net borrowing from the central bank to zero.

Pakistan's current account deficit widened to $2.57 billion in July and August, the first two months of the 2008/09 fiscal year. That is equivalent to about 1.6 percent of gross domestic product, compared with a full-year target of 6.0 percent.

Foreign reserves have fallen below $9 billion, having hit a record high of $16.5 billion in October last year, while inflation is more than 25 percent. Pakistani stocks have fallen 35 percent this year and the rupee has weaked by 20 percent.

Zardari said he saw a new beginning for the economy "marked by a programme of restoring investor confidence, resumption of foreign investment, gradual build-up of reserves, exchange rate stability and, above all, the revival of sustainable growth."

He did not elaborate.

He said ties with India were being driven by enhanced trade and Pakistan wanted all outstanding issues with its nuclear-armed neighbour, including Kashmir, resolved and peace and normal relations restored.

Zardari said parliament would be supreme and he would always seek its guidance. He called for a committee to "revisit" constitutional amendments introduced by Musharraf that give the president sweeping powers, including the authority to dismiss parliament. (Additional reporting by Aftab Borka; Writing by Robert Birsel)