By a Reuters staff reporter

Developing Myanmar will be impossible without peace in restive areas of the country, opposition leader Aung San Suu Kyi said on Friday in a region where fighting has raged since June between the army and ethnic Kachin rebels.

Suu Kyi, the 66-year-old Nobel Peace laureate, is seen as pivotal to Myanmar's nascent transition to democracy after five decades of military rule, and some believe she is the only figure who can unify one of Asia's most ethnically diverse countries and resolve the conflict in Kachin state.

Development is impossible without peace, she told cheering supporters in the state capital, Myitkyina, where she is seeking to build support for her National League for Democracy (NLD) party ahead of April 1 parliamentary by-elections.

The symbolism of the Nobel Peace laureate's visit to Kachin state goes well beyond the election.

The conflict in the Kachin hills near the Chinese border represents one of the last hurdles between Myanmar and a largely sanctions-free relationship with the West.

The ethnic minorities believe that she is probably the best person available to be part of the reconciliation process, said a Western diplomat. She's got the respect of the ethnic minorities.

The government, under President Thein Sein, has released hundreds of political prisoners, re-engaged with Suu Kyi after she was kept under house arrest for much of the past two decades, and appears to want free and fair by-elections a year after a nominally civilian parliament took office.

This week, the government reacted with uncharacteristic speed to a complaint from the NLD about campaigning regulations, which they swiftly changed.

The United States and European Union, which maintain economic sanctions on Myanmar in response to human rights violations, are openly discussing lifting the measures if progress toward democracy and human rights continues.

Everything else is going to plan except the situation in Kachin state, said a Myanmar-based aid consultant who declined to be identified.

HOLDING OUT

In Kachin state, many see Suu Kyi as their last hope.

At a Buddhist monastery sheltering villagers who fled the fighting, Than Nu, has a message for the long-detained opposition leader affectionately known as Auntie Suu.

We want to tell Auntie Suu that we want her to bring a peace agreement as quickly as she can, Than Nu, 46, said.

At a rally on Thursday in the town of Mogaung, about 40 miles (65 km) outside Myitkyina, Suu Kyi excited the crowd with a plea for peace and unity in the country also known as Burma.

The lack of peace in Kachin state is a sad condition not only for Kachin but also for the whole country, she told supporters packed on to a dusty soccer pitch.

The Kachin rebels, many of whom are Christian, are the last of Myanmar's many ethnic minority factions battling the army. Eight months of fighting have forced as many as 60,000 people into nearly 80 camps, like the one where Than Nu and her family were living, according to aid group estimates.

The new civilian government has reached ceasefires with other armed groups including Karen rebels based near the border with Thailand, and the Shan in the northeast.

But the Kachin are holding out for more than a ceasefire. They say they gained little in the way of autonomy from a 1994 ceasefire deal that collapsed in June. Several rounds of peace talks with the new government have been inconclusive.

The government doesn't want to talk politics, just ceasefire and development, but that is meaningless for the ethnic people, said a prominent Kachin Christian leader in Myitkyina, who declined to be identified. All the ethnic people want a federal system, he said in his church office.

And this is where some pin their hopes on Suu Kyi. Sixty-five years ago this month, when she was not yet two years old, her father, independence leader General Aung San, signed a deal with the Kachin and two other ethnic groups that granted full autonomy in internal administration.

But the deal, known as the Panglong Agreement, died when Aung San was assassinated in Yangon five months later.

UNFINISHED BUSINESS

Suu Kyi is running for a seat in parliament herself in a district near Myanmar's biggest city, Yangon, and is virtually guaranteed victory. There is talk she might take up a government post, perhaps leading ethnic reconciliation efforts.

This is an unfinished legacy of her father, said the Western diplomat. I think she recognises that it is going to be a central challenge for Burma.

Indeed, the significance is not lost.

If we want to develop our country, firstly we must have internal peace. The basis of internal peace is understanding each other, trusting each other, respecting each other. In short, this is the 'Panglong Spirit'. I believe that we must have domestic peace with the 'Panglong Spirit', she said.

What exactly that means in practice or how it will play out is unclear. But in Kachin state, it was a welcome message.

Peace is the main thing our country needs, said Sai Khon, a 23-year-old Kachin woman at one of the rallies.

But, for now, fighting goes on.

Thein Sein has called several times for the army to stop attacking the rebels but in an apparent sign of limits to his power, the clashes continue.

Ultimately, reconciliation with minorities could hinge on change to the constitution, drawn up under army supervision, which is not clear on any autonomy under a federal system.

The fighting could go on a long time, said the Kachin Christian leader. There is a little bit of hope in Suu Kyi. If she takes a leadership role we will see a change. The Myanmar issue is not democracy. The Myanmar issue is ethnic affairs.

(Editing by Jason Szep and Robert Birsel)