KUALA LUMPUR, Feb 1 (Reuters) - The ruling coalition of Malaysian Prime Minister Najib Razak may delay some planned economic reforms as tensions rise over the trial of opposition leader Anwar Ibrahim and ethno-religious rivalries.
Sovereign 5-year credit default swaps for Malaysia MYGV5YUSAC=R are trading at a spread of around 101.67 basis points, compared to a weighted average of 134.40 for the Thomson Reuters Emerging Asia Index. The implied risk of a Malaysian default is seen as lower than Thailand, with a spread of 111.00 basis points, and South Korea at 103.75, but higher than China, Hong Kong and Singapore.
Following is a summary of key Malaysia risks to watch:
* POLITICAL CONFLICT
The National Front which has ruled Malaysia for 52 years recorded its worst performance in last year's general election, losing control in five states and its once iron-clad two-thirds control of parliament. Voters, especially the country's Chinese and Indian ethnic minorities, abandoned the National Front in favour of Anwar's three-party opposition.
Anwar's upcoming trial on renewed sodomy charges will provide a flashpoint. Malaysia's political stability has deteriorated significantly over recent years, and investment will be further damaged if that trend continues.
What to watch:
-- Anwar's trial. Opposition supporters widely regard the trial as politically motivated, and it is likely to further dent Malaysia's attractiveness for foreign investors. If a contentious or divisive verdict seems likely, more foreign money will be pulled from Malaysia's markets, pulling down stocks .KLSE, bonds and the ringgit MYRX=. But with limited foreign portfolio investment still in the country, the impact will be muted.
-- A leadership tussle in the Malaysian Chinese Association, the second biggest party in the ruling National Front coalition, might drive more Chinese voters to the opposition.
* ECONOMIC REFORM
The government has promised further economic reform to attract more foreign investment. Najib has rolled back elements of a four-decades old Malay affirmative policy, relaxing the rule that companies must offer stakes to indigenous ethnic Malays. But Najib is wary of upsetting the Malays, a critical vote bank, and treads carefully on economic reform. This may cause him to dilute or abandon his plans as he attempts to remain in power.
What to watch:
-- Government policy implementation and announcements. A further bout of liberalisation has been trailed by the government, although while investors have greeted positively measures so far, little money has flowed into Malaysia's markets as they are wary over implementation.
-- The government's moves to reduce crippling fuel and food subsidies. Past fuel price hikes have drawn an intense public backlash, so the reaction to the government's expected announcement of a two-tier fuel price in May will be key.
-- The appointment of a new head of state oil-firm Petronas, with President and Chief Executive Officer Hassan Marican's contract reported to expire in February. A failure either to extend the contract of Hassan -- who is renowned for his no-nonsense approach in running the oil firm -- or to replace him with a rank outsider may be read as an attempt to put in place an executive more pliable to government whims, which could sour market confidence.
* RACE AND RELIGION
Race and religion have always been explosive issues in Malaysian politics. Najib took power pledging a more inclusive approach to ethnic Chinese and Indian minorities, but his United Malay National Organisation (UMNO) party that is the lynchpin of the ruling coalition cast this approach aside to try to prevent further loss of support amongst its Malay powerbase.
Najib, who took office in April last year, received a boost in approval ratings following measures to liberalise the economy and a pledge to promote inclusiveness. His gains, especially among minority ethnic groups, are in doubt after religious tensions flared over whether Christians could use the word "Allah" to describe God. The row sparked anger among ethnic Malays and deep unhappiness among non-Muslims.
What to watch:
-- If religious tensions worsen, the government may decide to put on hold further measures to withdraw special privileges for ethnic Malays in case this worsens Malay discontent and undermines support for the government. A severe worsening of tensions could raise the spectre of sectarian unrest.
-- If the government tries to woo Muslim voters with more conservative policies based on Islam, investors may be spooked.
Malaysia used to be regarded as one of the region's more reliable countries but worsening corruption and a perceived lack of judicial independence have damaged investment.
What to watch:
-- Government efforts to deal with a scandal over a port trade zone close to the capital of Kuala Lumpur that exposed links between politics and business. False government guarantees given when the bonds were sold have triggered concerns among holders of $1 billion of bonds that they might not be repaid.
-- How Najib handles the dilemma of bolstering his core support bloc while also cracking down on corruption. Investors are watching to see whether promised reform materialises.
-- Indicators gauging corruption in Malaysia. Transparency International's 2009 Corruption Perceptions Index saw a significant deterioration in Malaysia's ranking to 56th out of 180 countries from 47th the previous year.
The insurgency in southern Thailand has implications for Malaysia, particularly if it starts to draw more attention and sympathy from Malaysians for the ethnic Malay fighters across the border. A less likely danger is that al Qaeda-linked groups manage to establish a foothold in the area.
Much of the leadership of regional al Qaeda offshoot Jemaah Islamiah came from Malaysia or spent considerable time there. The main JI organisation is thought to have abandoned violent attacks on foreign targets but splinter groups remain at large.
In January, police said 10 people, nine of them foreigners, had been arrested on suspicion of links to international militant groups. Local media reports that the suspects were linked to the Nigerian passenger who tried to detonate a bomb on a flight into the United States on Dec. 25 could not be verified.
What to watch:
-- Signs the insurgency in Thailand is becoming more of a political issue in Malaysia could worsen regional tensions and unsettle markets. Any evidence al Qaeda is gaining traction in the region would also be a negative factor for markets. (Editing by Andrew Marshall)