MSCI MSCI Inc

SHANGHAI—Where Pakistan has succeeded, China has once again failed.

MSCI Inc.'s decision not to include Chinese stocks listed on the mainland in its key Emerging Markets index, tracked by $1.5 trillion of funds world-wide, comes despite rushed efforts by Beijing in recent weeks to show its markets are now reformed enough to merit inclusion, following two previous rejections since 2014.

In a statement accompanying its verdictâ "delivered as MSCI also said it would admit Pakistani stocks to the index for the first time—the index provider pointed to a key remaining issue for investors when it comes to Chinese markets: their ability to get money in and out of the country without limits.

Despite some opening up in recent years, Beijing remains reluctant to allow capital to flow freely across its borders. While the government is happy for more foreign money to flow into Chinese stocks, it is wary of rapid outflows when trouble hits.

"I'm very happy that MSCI called it out," said Karen Wong, head of equity portfolio management at Mellon Capital Management. "They [the Chinese authorities] have probably only done half of what MSCI has asked for," she said.

Ms. Wong said the fact that each month investors are only able to repatriate an amount equivalent to up to 20% of the assets they held in China at the prior year-end means it could be hard to get money out of the country in a crisis.

"The market is probably OK unless you have people running for liquidity," she said. "Then there can be a cascading domino effect. We saw it less than 10 years ago during the global financial crisis," she said.

Despite such key reservations among big foreign fund managers, many analysts outside China had expected MSCI to give A shares the nod this time. Goldman Sachs had said there was a 70% chance A shares would be included before the decision. Its China strategist Kinger Lau said Wednesday the non-inclusion was a "surprise."

Guillaume Derville, head of Asia Equity and Derivative Strategy at BNP Paribas, said MSCI's decision was "somewhat disappointing", adding that Chinese regulators had addressed many of investors' concerns in the past year.

By contrast, Chinese investors seem to have anticipated the news. Disillusionment with stock investing has grown within China in recent months after a tumultuous 2015, during which stocks first surged 43% before plunging sharply.

Trading volumes have slumped in recent weeks with trading largely flat, although shares in Shanghai rose 1.5% at the midday break Wednesday after the MSCI announcement—a contrast to the slump in Chinese shares that followed MSCI's decision a year ago not include them in its indexes.

"As long as China's stock market remains one where the regulator acts like a parent and retail investors behave like kids, and everyone still expects the government to bail out a crashing market, it won't meet MSCI's criteria," said Shen Meng, director at Chanson & Co., a Beijing-based boutique investment-bank.

"China will always have a tightly managed system. If you allow rapid and massive capital inflows or outflows, our market will also suffer from very sharp swings," said Mr. Shen.

The China Securities Regulatory Commission said that any international index without A shares is incomplete and that its domestic equities market is gaining international influence.

A Chinese official close to the agency said that in the past few months, there has been "lots of interaction" between the agency and MSCI, adding that the agency has "done a lot" to try to meet the MSCI's demands.

Late last month, for example, the CSRC introduced new guidelines aimed at limiting the frequency with which Chinese companies indefinitely suspend their shares from trading.

Still, regulators' top priority for the market has been maintaining its relative stability over the past few months. Under the new CSRC chairman, Liu Shiyu, the agency has been slow to push through other reforms such as establishing a more market-oriented system for initial public offerings and has instead emphasized "caution," officials close to the agency said.

A long-planned trading link between Hong Kong and the Shenzhen market which would allow foreign investors more opportunity to trade on the mainland is still yet to be launched.

Mr. Liu replaced the beleaguered Xiao Gang in February, who was fired from the post by the leadership following a $5 trillion stock-market rout last summer and a botched market-rescue effort.

Given the current political emphasis on stemming capital outflows, China isn't likely to soon lift the restrictions on foreign investors redeeming their stock investments in China as called for by the MSCI.

"That's not up to the CSRC alone," said the official close to the agency.

For many others in China, the latest knock back from the MSCI could yet prove water off a duck's back.

"When Deng Xiaoping died in 1997, the Shanghai market opened lower by 100 points but then swiftly resumed moving on its own trajectory rather than crashing further," said 64-year-old retail investor Ma Zhigang, a retired worker from Shanghai.

"It's not surprising that MSCI said no again, because China's stock market remains highly speculative," Mr. Ma said. "If China opens a casino, it will be the world's biggest one," he added.

Lingling Wei, Yifan Xie and Chao Deng contributed to this article.

Write to Shen Hong at hong.shen@wsj.com

(END) Dow Jones Newswires

June 15, 2016 04:15 ET (08:15 GMT)

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