By Michelle Price and Pete Sweeney
HONG KONG/SHANGHAI (Reuters) - U.S. index provider MSCI Inc (N:MSCI) has told China it must further liberalise its capital markets before it will include Chinese domestic shares in one of its global benchmarks, in a setback for Beijing's efforts to promote its currency and attract foreign capital.
Despite a recent acceleration of its reform agenda, MSCI said global investors wanted China to go further in removing barriers that make it difficult for foreigners to invest in the country before it includes so-called "A" shares in its Emerging Markets Index <.MSCIEM>. tracked by $1.7 trillion of funds.
China stocks opened down on Wednesday after the news, with the CSI300 index (CSI300) falling 1.2 percent, while the Shanghai Composite Index (SSEC) lost 1.3 percent, but later edged back into positive territory.
In the run-up to Tuesday's decision, some foreign investors had worried about the potential disruption and cost of being pushed to invest in China's volatile $9 trillion stock market if "A" shares were included in MSCI's widely tracked benchmark.
"This is a welcome reprieve for global investors and I suspect there has been a collective sigh of relief from the asset management world this morning," said Jonathan Ha, chief executive of Red Pulse, a Shanghai-based markets research firm.
"The ball is in China's court in terms of addressing the quota and ownership issues, but this is also a gentle nudge for managers to get ready. I think the remaining issues could be addressed in between three to six months."
A decision to include domestic Chinese stocks in the index would have injected an estimated $400 billion of funds from asset managers, pension funds and insurers into mainland China's equity markets over time, MSCI has estimated.
But MSCI's hesitation reflects reservations on the part of foreign fund managers regarding Beijing's willingness to fully open up its capital markets, with China's investment quota system remaining a "very significant" barrier, said Remy Briand, MSCI managing director and global head of research.
China's use of quotas to control the amount of money that comes into its market is not fully transparent and does not give equal market access to all money managers.
"All investors would need to have quota to ensure a level playing field," Briand told Reuters in Hong Kong on Wednesday.
MSCI also said it was critical to be able to get money in and out of China on a daily basis, which is not currently possible for all investors. Investors also lack confidence that their ownership rights will be recognised under Chinese law.
Briand said MSCI would continue to evaluate China's reforms in their "entirety", but declined to give guidance on when he expected the issues to be resolved. He added that MSCI could push a decision to beyond June 2016 if the index provider feels more time is needed.
MSCI would give investors 12 months between an announcement and implementation for including China A shares in the index.
WAKE-UP CALL
This is the second time MSCI has given China the thumbs-down. MSCI originally proposed in March 2014 to include Chinese "A" shares to its Emerging Markets Index, but the plan was torpedoed by large funds such as Vanguard, Fidelity and Templeton, which said China had not taken sufficient steps to facilitate investment in its market.
"Fund managers gave up on China two years ago, and there are many foreign managers who are still very reluctant for 'A' shares to be included," said Francois Perrin, head of Greater China equities for BNP Paribas (PARIS:BNPP) Investment Partners in Hong Kong.
"But today's decision should be a wake-up call for the asset management industry: time is running out to prepare and you cannot be late for this."
Expectations that MSCI would include China's "A" shares this year increased following the landmark November launch of the "Stock Connect" trading link between Hong Kong and Shanghai. The link allowed foreign investors for the first time to buy domestic Chinese stocks directly via Hong Kong.
MSCI also cited the Stock Connect programme as well as the imminent launch of the Shenzhen-Hong Kong Stock Connect programme as positive developments.
Chinese stock markets, which languished in the basement for years in the aftermath of the global financial crisis, have turned into world-beaters in the last year, with the CSI300 index (CSI300) of the largest listed firms in Shanghai and Shenzhen soaring about 150 percent in the last 12 months.
Chinese "A" shares are listed in Shanghai and Shenzhen and denominated in yuan.
There was no immediate response to the decision from China's stock market regulator, but China's official news agency Xinhua said the announcement showed China's "A" shares were "on track" for inclusion.
