* MSCI defers inclusion of China A shares for second time
* Inclusion could bring $400 bln over time into China stocks
* MSCI, foreign funds say China must open capital markets more
* Funds fear being unable to freely exit China once invested
* MSCI caught between China’s ambitions, investors’ caution
By Pete Sweeney and Michelle Price
SHANGHAI/HONG KONG, June 11 (Reuters) - MSCI’s decision to defer including Chinese shares in its emerging market benchmark share indexes for a second time may have trapped the index provider into making promises it can’t keep, both to Beijing and to its investor constituents.
While both MSCI and Chinese state media spun the decision as a speed bump on the way to inevitable inclusion, which will allow and in some cases require foreign funds to buy into Chinese stocks, the agendas of Chinese bureaucrats and foreign institutional investors are much further apart than they seem.
“With this announcement (MSCI has) further hemmed themselves in, as they’ve outlined exactly what China needs to do. And if China satisfies them, they’ll be within their rights to ask why MSCI hasn’t lived up to its side of the bargain,” said one source familiar with MSCI’s strategy.
MSCI’s clients want Beijing to open its capital accounts so they can reliably move their money in and out of China’s markets, but the economy is facing its slowest growth in decades, which has led to capital flowing out of the country.
For China, inclusion in the index could over time bring an estimated $400 billion into its stock markets and would help in its drive to internationalise the yuan currency.
That might encourage Beijing to try to do the bare minimum to check MSCI’s boxes without facilitating further outflows during its current economic slowdown, and therefore without addressing the real source of offshore fund managers’ anxiety.
Some of China’s market-oriented government economists have publicly lobbied against more opening, warning it could destabilise a financial system still struggling to rationalise itself.
“China’s financial sector is one of its Achilles’ heels,” said Xiao Lian, senior economist at the government-run Chinese Academy of Social Sciences (CASS).
“Banks cannot cope with a sudden market opening, and it will be even more difficult to control if they (further) open up the financial markets.”
But controlling these flows means keeping in place the very quotas and restrictions that the foreign fund managers told MSCI are unacceptable.
“Many investors have stayed away from China because of the quota system, and the fear that they won’t easily be able to adjust their portfolio or exit their investments,” said Wayne Bowers, chief investment officer EMEA and APAC, Northern Trust.
Given the current mainland stock rally, which has pushed Shanghai stocks up nearly 150 percent in 12 months, foreign investors are nervous about getting left in the market during a selloff.
“Foreigners are not that stupid to come into the stock market now,” joked one retail investor in a social media post in reaction to the MSCI decision on Wednesday.
“But we’ve been mistreated by foreigners for 200 years; why can’t we mistreat them just once this time around?”
The source familiar with MSCI’s strategy said major U.S. funds were so resistant to inclusion they threatened to abandon its emerging market benchmark.
There’s also a legacy of distrust of Beijing’s intentions; pessimists argue that a series of pilot programmes to open up parts of the capital account offer the appearance of reform without the substance of fair treatment of foreign investors and a stable legal regime that regulators abide by.
That distrust is amplified by Beijing’s historical preference for giving itself the maximum amount of room to adjust policy on the fly, especially when it comes to capital being allowed out of the country, leading to a record of delay, revision and retreat.
Vijay Sumon, an analyst at HSBC in London, cited the example of the Shanghai-Hong Kong Stock Connect scheme, which was launched in November last year, later than expected, and before some of the wrinkles - such as the tax treatment of gains - had been ironed out.
“You saw what happened with Stock Connect; it was delayed,” he said.
“MSCI doesn’t want to be put in a position where they may have to delay.” (Additional reporting by Lisa Jucca and by Kevin Yao in BEIJING; Editing by Will Waterman)