MSCI Inc.’s decision to defer including Chinese shares in its emerging market benchmark share indices for a second time may have trapped the index provider into making promises it can’t keep, both to China and its investor constituents.

    While both MSCI and Chinese 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 officials 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 says the process requires time.

    “It wouldn’t be a negative, it would simply be the recognition that this process needs to take its own pace,” said Remy Briand, MSCI managing director and global head of research, when asked whether there could be fallout for the company if it finds itself delaying inclusion again next year.

    The changes foreign fund managers want are not minor tweaks.

    MSCI’s clients want China 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.

    Some US$1.7 trillion in investor money is benchmarked against MSCI’s emerging market indices, according to data from June 2014. For China, inclusion in the index could over time bring an estimated US$400 billion into its stock markets and would help in its drive to internationalize the yuan currency.

    That might encourage China 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 destabilize a financial system still struggling to rationalize 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 China 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 Wednesday.

    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.

    Also, foreign investors remain cautious when buying yuan assets due to a lack of knowledge of the market and regulatory issues.

    Many global funds still have no or negligible exposure to yuan assets, though the yuan has become the fifth most-used currency globally and China is the world’s second-largest economy.

    As an example, Canadian Pension Plan Investment Board has only 1 percent of its portfolio allocated in yuan assets.(SD-Agencies)