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TAIPEI, May 31 (Reuters) - The threat of military conflict between Taipei and Beijing has faded, transforming the appeal of Taiwan for foreign investors, but policy risk and the threat of polarised local politics could cool the investment climate.
Following is a summary of key Taiwan risks to watch:
Taiwan's central bank said in March it was ending its loose monetary policy due to signs a deep recession was over, but economists expect interest rates to stay relatively low for a few months more unless the U.S. Fed acts sooner or inflation spikes persistently. Faced with growing discontent over rising housing prices and fears of a real estate bubble in an election year, the central bank may move to curb property prices and speculation.
Another key issue is coping with flows of "hot money" that have been buoying Asian asset prices. Some of this has already departed -- foreign funds sold a net $4 billion in Taiwan stocks .TWII in May due to risk aversion driven by the euro zone debt crisis. The interventionist central bank regularly moves 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. The Taiwan dollar is an ideal proxy due to the island's fast-growing trade ties with China while the central bank would allow some appreciation to keep the price fair.
What to watch:
-- Comments by ministers and the central bank on monetary policy, for hints of when the benchmark discount rate will be raised. The next formal meeting is in June. [ID:nTOE60I06T]
-- Signs that 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 in the Taiwan dollar due to a firmer yuan, which some economists see in the second half of the year.
-- A hike in reserve ratio requirements or other moves to control mortgage lending.
President Ma Ying-jeou's promotion of closer economic ties with China has boosted trade and reduced the risk of military conflict. The government is pressing ahead with an economic cooperation framework agreement, the precursor to a free trade deal, ideally to be signed in June though later if island officials do not see the deal they want
For full trade deal coverage, see [ID:nTOE64D06L]
Taiwan's stock market .TWII opened this year to qualified Chinese investors. 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. 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 closer 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.
-- Passage of the economic cooperation framework agreement. The economics ministry has not ruled out a post-June signing delay as the two sides haggle over tariff cut details. Factions of Taiwan's parliament and the island's anti-China main opposition party have raised questions that could delay it.
-- China and Taiwan are scheduled to talk again at the end of the year, possibly opening dialogue on sensitive topics such as media access and a new wave of tariff reductions.
-- 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.
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 have also raised 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 chill markets.
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 attentive to competitiveness, the government dropped 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)