* MSCI has slimmed down proposal to include 169 Connect stocks
* Investors, sources see greater likelihood of inclusion in 2017
* BlackRock says "supportive of" general benchmark inclusion
* Some investors still spooked by capital outflow curbs
By Michelle Price
HONG KONG, April 24 (Reuters) - The chances of MSCI Inc adding China-listed shares to its global index have risen significantly since it proposed to cut the number of companies to include, investors say, but capital controls and market access snags may still pose a hurdle.
New York-based index provider MSCI will announce in June if it will add yuan-denominated Chinese shares, or A shares, to its Emerging Markets Index, a move that could draw up to $400 billion into China stocks over the next decade.
MSCI last year declined for the third time to include mainland-traded shares to the benchmark, tracked by around $1.5 trillion in assets, saying more had to be done to open up the country's tightly-controlled market.
The index provider has now narrowed the gap between China and global asset managers by proposing a smaller slate of stocks and confining them to large-cap companies accessible to foreign investors via a trading link with Hong Kong.
"Certainly, in terms of the challenges China poses with respect to equity market access, this proposal does go some way to addressing those concerns," said David MacKenzie, head of Asian Equity Management at Schroders. "I'd be very surprised if they didn't push it through this year."
BlackRock - MSCI's largest client - said in a statement it was "supportive of" China A-share inclusion in global benchmarks but did not comment on the timeline or MSCI's new proposal.
MSCI said last June China needed to allow foreign investors to freely repatriate capital under its cross-border Qualified Foreign Institutional Investor (QFII) investment scheme.
It also wanted the country to scrap a rule requiring foreigners seek regulatory approval before launching investment products that include A shares, and said it wanted to see fewer long-term share suspensions.
Chinese regulators and benchmark providers have been in discussions for several years to smooth out market access issues, but have reached a deadlock over the last remaining hurdles, said two people briefed on the matter.
One of the people said MSCI was working around these last issues by reducing the proposed selection of 448 stocks to 169.
"This is a bit of negotiation with the investors on one side telling MSCI what they want to see, and the Chinese regulators on the other side saying this is what they can offer," said Daniel Morris, senior investment strategist at BNP Paribas Investment Partners.
"This latest proposal suggests MSCI is taking a quality over quantity approach. This seems like a good start."
The China Securities Regulatory Commission did not respond to a request for comment, while MSCI declined to comment.
MSCI will hold consultations with investors in the next few weeks and may still struggle to convince many who remain wary of Beijing's restrictions on capital outflows, some investors said.
"There is still a lot of pushback from investors due to capital outflow restrictions, so I would say the chances of global benchmark inclusion this year are still only around 50-50," one person closely involved in the discussions on benchmark inclusion said.
Others pointed out that the Connect scheme continues to have operational snags that prevent some investors from using it.
The smaller proposed number of stocks means the weighting of A shares in the index would be just 0.5 percent if MSCI proceeds in June, meaning around $12 billion would flow into Chinese shares, Nomura analysts said. China's equities market is valued at nearly $8 trillion.
"I do think this time round there is a greater likelihood of inclusion but it is a small selection of stocks and the actual investment amount is very small," said Yannan Chenye, portfolio manager and head of China research at Chinese asset management giant Harvest Global Investments.
"But inclusion would be very symbolic, meaning global investors would have to look at the China market more closely."
Editing by Jacqueline Wong