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UPDATE 3-China fumbles FTSE Russell's bond inclusion, Malaysia clings on

Noah Sin and Krishna N. Das

* China left out of key benchmark but still on-watch for upgrade

* Investors want more liquidity, hedging tools - FTSE Russell

* Large passive investor base requires better

* Malaysia stays for now; granted 6 months to make improvements (Adds FTSE Russell, investor and analyst comments, context; recasts throughout)

HONG KONG/KUALA LUMPUR, Sept 27 (Reuters) - FTSE Russell decided not to add China to its widely-tracked government bond index on Thursday as investors reiterated long-standing concerns, while Malaysia escaped eviction from the benchmark for at least six months.

The upset from the World Government Bond Index (WGBI) came after two other major fixed income indexes incorporated Chinese bonds this year -- a nod to Beijing's efforts to open up its financial markets amid a bruising trade war with Washington.

Scant trading activity in some government bonds, lack of flexibility in "FX execution" and longevity in settlement cycles were the key issues, FTSE Russell said on Thursday.

"Investors have expressed interest to be able to trade third party FX (and not be confined to one FX agent), have access to bond futures market and the onshore repo market," Goldman Sachs wrote in a note on Friday.

They said FTSE Russell's large passive investor client base requires these issues to be fully resolved "or else the inability to efficiently trade China bonds will likely lead to wider tracking error versus benchmark".

"There have been improvements, but I suspect not enough for the feedback to be resoundingly supportive, especially from the passive users," Adam McCabe, head of fixed income for Asia and Australia at Aberdeen Standard Investments, who called the decision "a bit of a surprise", said in emailed comments.

China has made it easier for foreign investors to trade its $13 trillion bond market in recent years. It launched 'Bond Connect' in 2017 to allow offshore trading of onshore debt, and scrapped some inbound investor quotas this month.

JPMorgan said in recent weeks it will include Chinese government bonds in its emerging market local currency index from February 2020. In April, Bloomberg Barclays Global Aggregate Index started adding Chinese bonds.

But the bar for inclusion is higher for FTSE Russell, said Nikki Stefanelli, head of fixed income index policy.

"WGBI is a relatively compact index that represents government bonds only. We have a higher threshold for credit rating requirements," she said in a phone interview.

"You don't have the smaller markets that some of the broad-based indexes tend to include."

Eventual inclusion could bring about $120 billion of passive inflows in the initial phase, Citi said in a note on Friday. China remains on FTSE Russell's watch list for a potential upgrade in March.

Attracting foreign investors into China's markets could help fund domestic investment and counter rising capital outflows as the local economy slows and the Chinese currency falters.

HANGING ON

Malaysia was given six months to try and improve liquidity and so avoid a damaging eviction of its government bonds from the WGBI. FTSE Russell will provide another update after an interim review in March.

Malaysian bonds were first put on a review for a downgrade in April. The country's bond market has the highest share of foreign ownership in Asia, and analysts said the additional time could help the central bank work on more measures to enhance liquidity on top of what has already been done.

Last month, Bank Negara Malaysia (BNM) announced additional measures to give more flexibility to foreign investors to trade in the ringgit, and for resident businesses to manage hedging of foreign currency risks, in an attempt to stay in the index.

BNM Governor Nor Shamsiah Mohamad Yunus said after its last policy meeting that the central bank had a "very positive engagement" with FTSE Russell about Malaysia's status in its government bond index.

"We think there could be more follow-up measures by BNM on fine-tuning of policies," Malaysia's Maybank Kim Eng said in a note.

BNM did not immediately respond to a request for comment.

Analysts at Morgan Stanley said earlier this year that foreign investors had cut their Malaysian government bond holdings since late 2016, and that nearly $8 billion could leave Malaysia if it was dropped from the index. Malaysia represents 0.39% of the benchmark.

"Apart from Malaysian bonds, a downgrade would hurt the ringgit, and in turn, the appetite for Malaysian equities as well," AmInvestment Bank said in a note.

Foreign holdings in Malaysia's bond market were about $157 billion in July. Malaysia's 10-year sovereign bond is the benchmark issue most widely tracked by foreign investors. (Additional reporting by Rodrigo Campos in New York; Editing by Catherine Evans)