FACTBOX-Key political risks to watch in Taiwan

TAIPEI, Sept 5 (Reuters) - The threat of military conflict between Taipei and Beijing has faded, raising the appeal of Taiwan for foreign investors, but sudden policy shifts and fractious local politics could cool the investment climate.

Following is a summary of key Taiwan risks to watch:

* INTEREST RATE POLICY AND CAPITAL CONTROLS

Taiwan's central bank raised interest rates in June for the first time since the crisis, and is expected to hike them 12.5 to 25 basis points each quarter through to end-2011 [ID:nSGE65N0D0]. However, some analysts say a severe enough slowdown in the U.S. economy could pause those hikes for a quarter or two.

The hikes signal that Taiwan authorities believe the $414 billion export-reliant island economy is gathering steam despite sluggish CPI [ID:nTOE63602D] and stubborn unemployment that remains at an unusually high 5.17 percent [ID:nTPV001880]. Forecast-beating GDP growth [ID:nTOE67F07A] gave support to this view.

The central bank also remains wary of "hot money" inflows that have buoyed Asian asset prices. Some of this money has already departed: Foreign funds sold a net $4 billion of Taiwan stocks .TWII in May and another net $1.25 billion in August due to risk aversion driven first by the euro zone debt crisis and later fears of a double-dip recession in the United States.

The interventionist central bank moves almost daily to stop speculation in the island's currency market, dealers in Taipei believe. Earlier this year it warned local and foreign banks to follow regulations when trading foreign exchange forward contracts, another move to discourage hot money [ID:nTOE60L08O].

But economists say the undervalued Taiwan dollar stands to catch up with other Asian currencies on any gains in the Chinese yuan CNY=CFXS, especially following Beijing's flexible yuan policy announced in June.

The Taiwan dollar is an ideal proxy for the nonconvertible Chinese unit due to the island's fast-growing trade ties with China, and the central bank is expected to allow some currency appreciation as a result of China's policy shift.

What to watch:

-- Economists expect the central bank to raise rates again at a quarterly policy meeting in September by 12.5 to 25 basis points, and make a similar move in December. [ID:nTOE65O026]

-- Capital controls could be tightened further if hot money resurfaces as an issue. This would push down the Taiwan dollar. However, analysts do not expect the kind of rigid capital controls that would cause major outflows. [ID:nHKG263506]

-- The central bank's response to any appreciation of the Taiwan dollar due to a firmer yuan.

* CHINA-TAIWAN RELATIONS

Taiwan President Ma Ying-jeou's promotion of closer economic ties with China after decades of hostility culminated on June 29 in a landmark free trade deal that cuts import tariffs on about 800 items and helps the island's financial sector. [ID:nECFA]

That economic cooperation framework agreement (ECFA) handily cleared the island's parliament in August, despite noise from the opposition, and is expected to take full effect on Jan. 1, setting the stage for talks with China on the next round of tariff cuts.

The deal also positions Taipei to sign free trade deals with its other major world trading partners [ID:nTOE67805H] as China is seen muting its usual opposition to such agreements. Beijing normally forbids its diplomatic allies, including the world's most powerful nations, from official deals with Taiwan as it sees the island as part of its territory rather than a sovereign nation. But Taiwan and Singapore, the island's No.6 trade partner, said on Aug. 5 they would begin FTA talks [ID:nTOE67400Q] and China voiced no objections.

In further signs of improved China-Taiwan ties, the island's stock market opened this year to qualified Chinese investors, while trade and shipping links established since 2008 will help boost trade and reduce the risk of military conflict.

But the issue of ties with China remains highly divisive in Taiwan and there is always the risk of new controversies, especially as 2010 is a local election year with the winning party having a strong shot at the 2012 presidential race.

In local elections last December, seen as a test of Ma's policy of engagement with Beijing, his government lost some ground to the anti-China opposition that Beijing hopes to keep out of power.

What to watch:

-- Washington is weighing Taiwan's request for F-16 fighter jets, a sale described as a "red line" for Sino-U.S. relations, and other arms packages, but any decision is not expected until at least 2011 as U.S. officials seek better China ties [ID:nTOE66M04U]. If a sale threatens ties with China, the impact on Taiwan asset prices will be negative, with stocks of firms that have benefited from greater access to China hit the hardest.

-- Results of the Nov. 27 local elections covering about 60 percent of the electorate and Taiwan's major cities. If the ruling party wins big, it signals support for more trade dialogue with China. If the opposition gains, China relations could sour.

-- Talks on further tariff reductions that could help Taiwan's biggest industries such as electronics, PVC plastics and machine tools. Beijing may resist making concessions on these as it wants to develop its own industries.

-- China's blessing for free-trade agreements between Taiwan and other governments, including the world's biggest economies, would advance Taiwan's long-term competitiveness strategy and signal improvement in Beijing's ties with Taipei.

* GOVERNMENT EFFECTIVENESS

Ma has a strong mandate to govern, as the KMT controls parliament and the presidency. This has bolstered government effectiveness and helped to avoid political deadlock.

But widespread criticism of the response to Typhoon Morakot last year dented government popularity and led to a cabinet reshuffle. That storm, the worst in 50 years, triggered mudslides that killed about 700 people.

A sudden deal in October to allow U.S. beef imports despite mad cow disease fears also backfired, prompting Taiwan's parliament to scrap part of the agreement and irritating Washington. Cabinet flaps that saw one minister quit and another offer his resignation have raised further questions about ruling party leadership ability [ID:nTOE62B01S], although the president has avoided major flaps over the past four months.

The high degree of polarisation between the two major parties, the China-friendly Nationalists (KMT) and the anti-China opposition Democratic Progressive Party (DPP), can undermine policy continuity and increase uncertainty.

What to watch:

-- Markets are unlikely to react to domestic political controversies unless they significantly weaken the KMT's hold on power, the strength of which will become clearer after the Nov. 27 local elections. If that happened, the risk of policy deadlock and frostier ties with China would be a drag on markets.

* ECONOMIC REFORM

Taiwan puts limits on foreign portfolio investment and restricts foreign direct investment in some sectors. As the economy recovers, investors will start to focus again on whether economic reform may relax some restrictions. In a sign of growing focus on competitiveness, the government has cut the corporate income tax rate from 20 to 17 percent. [ID:nTOE64S005]

What to watch:

-- Any announcement from the government on economic reform and specific measures to boost foreign investment. This would be broadly positive for the stock market.

(Editing by Andrew Marshall)