SHANGHAI (Reuters) - Barely a month after approving the inclusion of Chinese shares in its benchmark emerging market index, MSCI is warning that companies in China that suspend trading in their shares for too long risk being dropped.

The MSCI logo is seen in this June 20, 2017 illustration photo. REUTERS/Thomas White/Illustration

MSCI’s head of research for Asia Pacific, Chin Ping Chia, said China was an outlier in global markets with too many suspensions in stock trading. He said the U.S. index provider was closely monitoring the 222 China-listed A-shares that will be added to its Emerging Markets Index next year.

“If we find a company suspends for a long time, over 50 days, we will remove it from the index, and we will not bring it back to the index again for at least another 12 months,” Chia said.

The 12-month removal rule would be limited to Chinese companies. Companies from other markets who are removed from the index due to a long suspension of trading would be able to start a review process for reinclusion once they resumed trading.

MSCI’s comments come as the number of suspended stocks in China is at its highest level in a year after volatility in smaller companies prompted many to halt share trading in order to avert a crash in prices.

Suspensions have also increased among companies with larger capitalizations as Beijing steps up consolidation of state-owned enterprises.

An average of 265, or one in every 13, listed companies in China suspended trade in July, according to data provided last Wednesday by the fund consultancy Z-Ben Advisors. The consultancy said the number had risen every month this year and was now up 30 percent from an average of 202 in January.

Last year, MSCI cited arbitrary and long suspensions as a reason for vetoing the inclusion of shares listed on the mainland in its benchmark indices.

However, MSCI said in June this year that it would add 222 A-shares to the index in May and August next year, which could trigger billions of dollars of passive investment inflows into China.

“This suspension issue in China is highly unique, both in the number and frequency,” Chia said. He said that failure to address the issue could discourage MSCI from adding China stocks to its indexes in the future.

Investors have long worried about a tendency by Chinese companies to suspend trading in their shares. At the height of the 2015 stock market crash, over half of China’s 3,000-plus listed companies halted trading.

In May last year, both the Shanghai and Shenzhen stock exchanges tightened rules on share suspensions by listed companies, requiring them to disclose more details and to shorten the length of suspensions. These measures, however, have had limited effect.

A spokesman for the China Securities Regulatory Commission said at a press conference on Friday that Chinese regulators would work to improve suspension rules.

OUTLIER

Essence Securities, a Chinese brokerage, estimates that 8 percent of Chinese stocks could not be traded in May due to suspensions, compared with less than 1 percent in Hong Kong and roughly 4 percent on the Nasdaq.

MSCI’s Chia said that suspensions last for a day at most in most global markets, whereas in China, suspensions can go on for months.

In an extreme case, trading in shares of Xinjiang Yilu Wanyuan Industrial Investment, a loss-making ceramic products maker, has been suspended for about 20 months.

“The issue is that in a freely accessible market, investors want to be able to get in and get out. If a market falls, they still want to be able to get out,” said Chia. “But if you suspend, investors cannot get out, that will be a problem.”

Seasoned foreign investors in China’s A-share market concur.

“You can tolerate losing money, but you cannot tolerate not being able to trade,” said Anthony Cragg, a senior portfolio manager at Wells Fargo Asset Management who manages $2.2 billion in several funds - including one dedicated to China.

EXPLOITING LOOPHOLES

The rules announced last year specify that in the case of a private share placement, suspension time on the Shanghai stock exchange cannot exceed one month. The Shenzhen stock exchange stipulates a maximum of six months for a trading suspension in the event of a company restructuring.

Yet, plenty of companies, particularly smaller companies, are able to exploit these relatively loose suspension rules.

This month, when China’s start-up board ChiNext tumbled to 2-1/2-year lows, companies listed there - including H and R Century Union Corp, Xinlong Holding Group Co and Galaxy Biomedical Investment - quickly suspended share trading, citing various reasons, ranging from margin calls to restructuring, or waiting for the release of price-sensitive information.

Xu Caiyuan, a prominent activist investor, said many Chinese companies were “playing dead” to avoid price falls, so that major shareholders facing margin calls could maintain control by “trapping small investors.”