(Corrects number of foreign money managers and size of current quotas para 4, timing of regulator comments para 5, number of companies in China market para 16; clarifies role of A-shares para 2, sourcing para 6, explanation of Hong Kong shares para 16)
By Sujata Rao
LONDON, April 11 (Reuters) - The opening up of China's $3 trillion mainland share market, one of the world's last big investment frontiers, is setting the stage for a huge shake up of equity indices and global fund flows.
The A-shares of the giant stock markets of Shanghai and Shenzhen have long been no-go areas for international investors, who have been largely confined to the offshore, Hong Kong-listed H-shares that represent China in global equity indices.
These have taken most of the $50 billion or so that EPFR Global estimates has flowed to China equity funds since 1995.
That is about to change. Beijing is expanding its QFII and RQFII quotas, schemes that allow foreigners to buy local assets. Just under 200 foreign money managers now hold total quotas worth nearly $42 billion .
Regulators signalled earlier this year that a 10-fold quota increase is on the cards.
Expanding quotas that much would give foreigners access to 15 percent of the free float, index providers say, up from the current 1.3 percent, and the news triggered a 4 percent jump in the market.
Longer-term, it will allow the shares to blast into equity indices run by major providers such as MSCI and FTSE. They do not currently meet entry criteria for these indices because of restrictions on foreign ownership and on cash movement in and out of China.
"China A-shares is something we are taking very seriously," said Deborah Yang, head of index business in Europe for MSCI, which has $7 trillion benchmarked to its indices.
"It is one of the changes we are seeing which could be monumental for global equity markets."
To give an idea of the potential impact, Yang says that under a scenario where A-shares become fully accessible, China's weighting in MSCI's emerging stock index, tracked by $1.4 trillion, would jump to 30 percent from the current 18 percent.
China's share of MSCI's all-country index would meanwhile double to over 4 percent, Yang said, though she stressed that inclusion in indices depends on how fast the market is opened.
Donald Keith, deputy CEO of FTSE Indices, which has $3.5 trillion benchmarked, reckons Chinese A-shares will be in global indices within five years.
Keith declined to predict possible weightings but said full inclusion could see China jump to 4th place in the FTSE world index from 11th, leapfrogging Japan. In the emerging index, China's weight would be close to 40 percent.
"Index providers have to reflect available opportunities. It also means investors will have to take fairly substantial action on their portfolios," he added.
Investors without doubt are keen. The proof lies in the explosion of exchange traded funds or ETFs replicating the mainland market in recent years.
The market's plus is that it contains more than 2,400 companies compared to the 170 or so that trade in Hong Kong that represent China in global equity indices. They are also more likely to be consumer and retail firms, while big energy, telecom and financial firms dominate offshore listings.
"The A-share market is effectively a frontier market in the world's second biggest economy," said Karine Hirn, Shanghai-based partner in Swedish investment firm East Capital, which got a QFII license earlier this year.
"In terms of diversity and investment themes the A-share market is great, you get direct exposure to the Chinese consumer story."
Opening the market makes sense for Beijing, which is fed up with volatility in A-shares, fed by rumours and besmirched by insider trading scandals. Many of the problems are attributed to its 75 percent ownership by retail investors.
Offering greater equity access is also part of Beijing's plan to make Shanghai a global financial centre and to make the yuan used more broadly, analysts say.
"It's all part of China exporting itself to the world," said Bill Maldonado, Asia-Pacific CIO HSBC Global Asset Management.
But Maldonado also voices investors' fears on index impact.
"Not everyone will want to be benchmarked to an index that has so much weighting to one market. It raises the question of why should market cap drive benchmark weight and how much attention should you pay to them," he said.
So what will be the fallout if China swells share indices?
At stake is a huge amount of money. China, at almost half the emerging index, will mean a proportionate drop in other countries' weighting and potentially, investment inflows.
Russia's Sberbank, for instance, wrote that a 1 percent fall in Russia's 6 percent weight in the MSCI index in favour of China implies a $10 billion outflow from index-tracking funds.
Sberbank acknowledged that A share inclusion won't happen in one fell swoop. But it warned that the very possibility "creates an air of uncertainty across the EM index structures and, generally, means that investor preference for China funds is likely to remain in place."
Many will argue however that China is actually under-represented in benchmarks, given its size and economic strength.
Second, index officials stress inclusion will be gradual and over several years, proceeding after consultations with clients.
MSCI's Yang compares the process in China with Taiwan, which also had a quota system for foreigners and joined the emerging markets index gradually between 1996-2005. South Korea also took six years to get up to full weight, she says.
Similarly, Malaysia accounted for a third of the MSCI emerging index in 1988 while the United States comprises almost half the all-share index.
"There have been major changes in the EM index since inception in 1988...This kind of evolution will continue," Yang said. "Including China A shares could significantly add to the global opportunity set available to investors."
$1 = 6.2024 Chinese yuan Additional reporting by Michelle Chen in Hong Kong; Editing by Catherine Evans/Ruth Pitchford