May 31, 2018 / 9:06 AM / 3 months ago

UPDATE 1-Foreign funds only dip their toes into China stocks on eve of MSCI entry

* Just $1 bln flowed into Chinese stocks under Connect vs anticipated $10 bln

* Northbound stock connect flows a fraction of daily quota

* Analysts see more gradual inflows from MSCI inclusion (Updates inflow figures; adds investor comments)

By Samuel Shen and John Ruwitch

SHANGHAI, May 31 (Reuters) - Foreign buying of Chinese stocks were tepid on Thursday as benchmark indexes rose on the last trading day before mainland shares join MSCI's emerging markets index.

A rebalancing of portfolios by global passive fund managers, as well as from some active investors, had been widely expected to spark a rush in investment into China's capital markets on the eve of MSCI's June 1 inclusion.

But on Thursday, just $1 billion flowed into Chinese stocks via Stock Connect, a key cross-border channel linking mainland and Hong Kong bourses. Some had expected $10 billion of inflows on the day, although active funds have been gradually raising their investment in Chinese shares over the past two months.

"In our view, the upcoming MSCI inclusion will trigger further northbound inflows despite the weak market environment, and A-share valuations appear more attractive after the recent market correction," said Gao Ting, head of China Strategy at UBS Securities.

The June inclusion will see around 230 Chinese large-cap stocks, known as A shares, added to MSCI's emerging markets benchmark index with a 2.5 percent partial inclusion factor. The second phase of the inclusion will take place on Sept. 3.

China's MSCI entry will integrate the world's second-biggest equity market, with a total stock market capitalization of more than $8 trillion, into the global financial system.

For more stories on China's MSCI inclusion, click on

FINAL LIST

On Wednesday, MSCI tweaked the final list of companies, dropping embattled Chinese telecommunications gear maker ZTE Corp and four other firms whose shares have been suspended from trading.

Over the past two months, foreign investors have been ramping up investment in Chinese shares, including retailer Wangfujing Group, Shanghai Flyco Electrical Appliance and spirit maker Sichuan Swellfun , despite rising volatility triggered by fears of a Sino-U.S. trade war.

ZTE has been caught in the crossfire of the dispute and trading in its shares has been halted for two weeks.

On Thursday, northbound flows into Shanghai and Shenzhen amounted to about 6.6 billion yuan ($1.03 billion) - a fraction of the more than 100 billion allowed each day, but still higher than in recent days. There were also signs of stepped up buying in the last three minutes of trading.

But many foreign active fund managers appeared to have stayed on the sidelines.

"The inclusion of A shares in China has no meaningful impact on us because we are not interested in following the benchmark," said Justin Leverenz, portfolio manager and Director of Emerging Market Equities at OppenheimerFunds. "What we are passionate about is finding extraordinary companies regardless of where they are located."

Although the MSCI-related inflows will initially be small compared to the size of China's stock market, inclusion in the global index could spawn other funds and boost interest in Chinese companies over time.

"On a longer-term basis, the opening of China's capital markets represents a once-in-a-lifetime market event and will be one of the primary ongoing themes in the region for many years to come," said Will Stephens, Deutsche Bank equity strategist.

In the offshore yuan market there were signs of tight liquidity, but analysts said it was mostly due to month-end demand.

Hong Kong's offshore yuan overnight borrowing rate, or HIBOR, was fixed at 6.07100 percent, its highest since June 1, 2017. The offshore yuan also rose, and was trading 0.13 percent firmer than its onshore counterpart at 6.3995 per dollar as of midday.

More foreign participation in Chinese stocks could help improve investment culture, and press China-listed firms to bolster their corporate governance, said Bin Shi, head of China Equities at UBS Asset Management.

"Index inclusion will bring more long-term institutional investors into the A-shares market...which will change the market structure," Shi said, noting that the market is currently dominated by retail investors.

"As overseas investors become more active in the market, so listed companies in China will be under tougher scrutiny and they'll have to bring their disclosure and governance practices into line with international standards." ($1 = 6.4038 Chinese yuan)

Editing by Jacqueline Wong

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