By Michelle Price
HONG KONG (Reuters) - Connecting the giant stock markets of Hong Kong and Shenzhen is unlikely to fast-track the inclusion of Chinese shares in a major investment benchmark index as foreign access to China's markets is still restricted.
Approval this week for the long-awaited extension of the Shanghai-Hong Kong stock trading link to Shenzhen's $3 trillion market - and the scrapping of overall investment caps - advanced China's cause to have yuan-denominated Chinese A shares included in MSCI's Emerging Markets Index, but hurdles remain.
China wants its stocks included in the MSCI index as this is tracked by $1.5 trillion in global assets and could draw up to $400 billion into China's stocks over a decade. It has said that any global benchmark that doesn't include China A shares is incomplete.
Eighteen months after the Shanghai-Hong Kong Connect was launched, many foreign fund managers still can't invest through the link due to operational hurdles and legal issues with the way assets are safeguarded under its custody arrangements. China shares have to be held onshore by the Hong Kong exchange on behalf of beneficial owners.
Tuesday's approval for the Shenzhen link reaffirms China's commitment to reform, but is unlikely to be a deal-maker for MSCI, a New York-based index provider, investors and analysts said.
"It's getting China A shares one step closer, but there are other issues that MSCI needs to look at," said Arthur Kwong, head of Asia-Pacific equities at BNP Paribas Investment Partners. "The stock link market mechanism is not yet working perfectly, and there could be challenges launching products."
For a third year running, MSCI declined in June to add Chinese A shares to its emerging markets benchmark, saying China had more to do to open up its market.
Hong Kong Exchanges and Clearing CEO Charles Li said this week the approval for the Shenzhen link put A shares "on the right track" for inclusion, but acknowledged it did not solve all MSCI's issues. He said additional features and products may have to be added.
MSCI said in June it would not include China A shares in its benchmark index until China allows foreign investors to freely repatriate capital under its cross-border Qualified Foreign Institutional Investor (QFII) investment scheme.
It also wants China to scrap a rule requiring foreigners to seek Chinese regulatory approval before launching investment products that include yuan-denominated shares.
And MSCI is watching to see if recent rule changes to share trading suspensions in China and the granting of investment quotas are actually effective.
The launch of Shenzhen-Hong Kong Connect doesn't immediately fix any of these issues. China's regulators have met several of MSCI's demands over the past two years, but have not indicated if or when they may address the index company's outstanding concerns.
"Concerns over capital mobility, share suspensions and restricted availability of A-share products are still being addressed," said Wilfred Son Keng Po, a Hong Kong-based portfolio manager at global asset manager PineBridge Investments.
A spokeswoman for MSCI in New York did not respond to requests for comment, while representatives in Hong Kong could not be reached.
MSCI has been in discussions with Chinese regulators and the Hong Kong exchange over the past year and knew of the deal being negotiated on Connect quotas prior to June, said a person with knowledge of those talks.
While daily trading quotas for participants buying Shanghai and Shenzhen shares in the scheme are capped at 13 billion yuan ($1.96 billion) for each market, Hong Kong and China have agreed to scrap an aggregate quota, meaning investors could have unlimited access to Chinese shares over time.
Many U.S. and European investors can't benefit though because the scheme's operational and custody arrangements breach their legal mandates.
"Hong Kong-Shenzhen Connect is an add-on factor for MSCI, rather than a pre-requisite," said Ivan Shi, head of research at Shanghai investment consultancy Z-Ben Advisors. "No mention on Tuesday of any potential change to the beneficial ownership structure probably won't help big managers and institutional investors to use Connect."
Asked by Reuters in June if extending the Connect scheme to Shenzhen and removing the quotas would see MSCI move to include A shares, Remy Briand, global head of research at MSCI, said it would be positive, but added that many investors did not want to use the scheme due to these problems. "Hence it's not something that at this stage would be resolving the accessibility issues," he said then.
MSCI operates an annual review for A share inclusion, but has said it could hold an ad hoc review if the situation changes.
"The launch of Shenzhen-Hong Kong Connect would have little impact, if any, on MSCI's consideration to include A-shares, since accessibility is no longer its top concern," said Qi Wang, CEO of asset manager MegaTrust Investment Hong Kong, and a former head of MSCI China research.
"My suggestion to global investors is to avoid relying on an index provider alone to resolve their China investment issues."
(Reporting by Michelle Price; Editing by Lisa Jucca and Ian Geoghegan)