FACTBOX-Key political risks to watch in Taiwan

TAIPEI, July 1 (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 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]

The move signalled Taiwan authorities believe the $390 billion export-reliant island economy is gathering steam despite despite sluggish CPI [ID:nTOE63602D] and unemployment that remains at an unusually high 5.22 percent [ID:nTPV001677].

The central bank remains wary of flows of "hot money" 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 due to risk aversion driven by the euro zone debt crisis, though some of that crept back in June.

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

Taiwan has also advised foreign funds against investing in local time deposits and government bonds.

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. 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.

* CROSS-STRAIT 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]

Taiwan's stock market also opened this year to qualified Chinese investors. And new trade and sea links will also 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.

The most recent controversy was the Sino-U.S. row over Washington's planned $6.4 billion arms sales package to Taiwan.

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. If a sale threatens economic 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 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 like electronics, PVC plastics and machine tools. Beijing may resist making concessions on these as it wants to develop its own industries.

-- The chance of a historic meeting between Ma and Chinese President Hu Jintao, tipped to take place in 2012 if Ma wins re-election that year. It would signal strongly improved ties.

* 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. 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 raised further questions about leadership ability [ID:nTOE62B01S], and in recent months the government has been pressured to make final rulings on 40 death row inmates after a five-year capital punishment hiatus. [ID:nTOE63T098]

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 be impacted much by any 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 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 measures to boost foreign investment. This would be broadly positive for the stock market.

(Editing by Andrew Marshall)