By Manny Mogato

MANILA, Aug 11 (Reuters) - Fierce clashes between Muslim separatists and government troops have displaced nearly 130,000 people in the southern Philippines, officials said on Monday, but vowed to press on with a local election.

The separatist Moro Islamic Liberation Front had called for elections in the six-province Autonomous Region of Muslim Mindanao to be cancelled because they want a new Muslim homeland with more political powers established as part of a comprehensive peace deal.

Air force planes bombed suspected MILF positions in North Cotabato province on Sunday after hundreds of guerrillas refused to leave Catholic farmlands they have occupied since last month.

But the military said the escalating violence would not halt voting in local elections in Muslim areas elsewhere on the resource-rich southern island of Mindanao on Monday. For story click on [nMAN50920]

"Fighting has not spilled over to the Muslim areas," Brigadier-General Jorge Segovia, an army spokesman, said. "We have sufficient forces to contain the violence in North Cotabato."

Nearly 130,000 people fled their homes and more than half were staying in temporary shelters. Dozens of houses were destroyed, disaster official said.

An agreement on the size of a Muslim homeland and a future government's powers, including rights over exploring and developing mineral reserves, oil and gas, was halted last week by the Supreme Court amid protests by Catholic politicians.

"We really wanted the elections postponed because it could delay the implementation of any agreement that would be reached if the two sides conclude a deal by November 2009," Mohaqher Iqbal, MILF chief peace negotiator, told Reuters.

Legal experts say the Supreme Court will likely rule the territorial deal unconstitutional and order the MILF and the government back to the drawing board.

Traders in Manila said the elections and violence were having little impact on sentiment for the peso, bonds and stocks.

The main stock index <.PSI> was up 3 percent hitting four-month highs on the back of Wall Street's rally on Friday.

The peso <PHP=> was quoted at 44.46 against the dollar, slightly weaker than Friday's close at 44.34 due to dollar strength.

"Unless we get a full-blown war over there then that's the only time it might significantly affect," said one foreign exchange trader

Election officials said despite the violence turnout was good with queues outside polling stations before voting started. Automated counting will be used for the first time.

"It seems that we are having a good election, and the people, our brothers and sisters in the south are showing us the way," Jose Melo, head of the elections body, said.

An estimated 1.6 million voters will choose a new governor, a vice governor and 24 members of a regional legislative assembly that would serve a three-year term.

(Reporting by Manny Mogato; editing by Carmel Crimmins and Sanjeev Miglani)