By Andrew Galbraith and Noel Randewich
SHANGHAI/NEW YORK (Reuters) -Index provider FTSE Russell has given final approval for inclusion of Chinese sovereign bonds in its flagship bond index from later this year, setting the stage for billions of dollars of inflows into the world's second-largest economy.
But a longer-than-expected inclusion period - of 36 months, rather than one year, as FTSE had previously announced - reflects persistent concerns among some global investors about investing in the world's second-largest bond market.
Chinese government bonds (CGBs) will be added to the FTSE World Government Bond Index (WGBI) over three years from the end of October, FTSE Russell said in a statement released after the U.S. market close Monday.
FTSE said "a more conservative" schedule was appropriate because of feedback from market participants, which had included concerns from Japanese investors around settlement and liquidity.
"The nature of the investors (tracking WGBI) is very different from other indexes," said Zhanying Li, Asia Pacific ex-Japan head of product sales and relationship management at FTSE Russell. "There's a large passive investor base behind WGBI ... the preference was for a small monthly increment."
Japanese investors, including Japan's 172 trillion yen ($1.56 trillion) Government Pension Investment Fund (GPIF), are the biggest users of WGBI.
Analysts say that historical animosity between China and Japan has contributed to concerns over investment in Chinese assets.
A source familiar with negotiations over China's inclusion said it continued to draw "emotional" opposition from investors in Japan. "Public pension is in the end citizens' money and some citizens may not like allocation to China," the source said.
FTSE Russell is able to provide custom variants of the index for investors with concerns about investments in CGBs, said FTSE Russell's Li.
Li said that smaller monthly increments over a longer period are also less likely to cause inflow-related volatility in Chinese markets, but added that Chinese regulators had not expressed concerns to FTSE Russell over issues caused by possible rapid inflows.
China's top banking and insurance regulator said in early March that Beijing is studying ways to manage capital inflows to prevent turbulence in domestic markets.
Chinese government bonds were previously included in index suites from JPMorgan and Bloomberg Barclays, but FTSE WGBI inclusion is expected to have a larger effect due to the size of passive flows tracking it.
HSBC said that with roughly $2.5 trillion tracking the WGBI, some $130 billion in inflows could be expected, given China's eventual 5.25% weighting - about $3.6 billion a month.
"From a global perspective, it improves inclusion statistics of the index - not having the second-largest country in it was a gap," said Binay Chandgothia, a portfolio manager at Principal Global Investors in Hong Kong.
"It will also pull up the index yield a bit," he said, though adding that would be limited by China's modest weighting.
China's debt is already increasingly popular with global investors, attracted by its yield and its relative insulation from movements in other bond markets.
Foreign investors held a record 2.06 trillion yuan ($318.7 billion) of Chinese government bonds (CGBs) in February, even as premiums over U.S. debt shrank as a bond sell-off dented global markets.
Benchmark 10-year CGBs yielded 3.202% on Tuesday, compared with a 1.7419% U.S. 10-year yield.
In its statement, FTSE Russell also said India and Saudi Arabia were being considered for potential inclusion, and that Malaysia was no longer on a watch list for exclusion from WGBI.
($1 = 109.9400 yen)
(Reporting by Andrew Galbraith in Shanghai and Noel Randewich in New York; Additional reporting by Tom Westbrook in Singapore; editing by Jane Wardell, Kim Coghill & Shri Navaratnam)