By Ross Kerber

A U.S. congressional examination of Chinese stock holdings in BlackRock funds built on MSCI indexes could presage a broader clampdown on U.S. institutional investment in such shares, analysts said, as Washington fears American capital could help Beijing gain military or technological advantages.

Relations between the two countries are at a low point amid friction on issues including Taiwan and the Ukraine war. The Biden administration is weighing new restrictions on outbound private investment in China on top of existing bans on certain technology sales and other trade measures.

A U.S. congressional committee said earlier this week that BlackRock and index provider MSCI were facilitating investments in companies that Washington has tied to Chinese human rights abuses or its military.

The House of Representatives' Select Committee on the Chinese Communist Party sent detailed questions about how the Chinese shares came to be included in products like BlackRock's iShares MSCI Emerging Markets exchange-traded fund.

The committee has also questioned other companies over their China ties, and analysts said more such reviews and increased restrictions on U.S. investing in Chinese shares were likely.

"I'm telling (clients) to expect more and stronger actions prohibiting or making it more difficult to invest in China, and greater scrutiny of those investments," said Jo Ritcey-Donohue, an attorney who advises institutional investors.

"As long as all these cross-border tensions are out there, there’ll continue to be pressure on U.S. businesses.”

BlackRock said on Tuesday it is one of 16 asset managers offering U.S. index funds holding Chinese companies. It said it complies with all U.S. laws and will engage with the select committee.

MSCI said it is reviewing the committee's inquiry.

RUSH OF MONEY

The degree to which Western capital enables authoritarian regimes has been a long-simmering issue, intensified by a rush of money into low-cost index funds.

For institutional investors, China, as the world's second-largest economy, is an important component in international portfolios and indexes. Chinese companies including Tencent and Alibaba accounted for 31% of the MSCI Emerging Markets index in July.

Committee Chair Mike Gallagher has said the U.S. companies were not doing anything illegal but that Congress needs to close loopholes.

In an interview on Thursday, Gallagher said he is not calling "for a complete cut-off of our economic relationship with China." But he said the committee is debating "this question of guardrails on outbound capital flows."

His committee can make policy recommendations, and a hard line toward China has bipartisan support.

Todd Rosenbluth, head of research for financial analysis firm VettaFi, said while BlackRock and MSCI are the most prominent firms in the index-investment space, new laws or regulations that emerge from the probe also would likely apply to competing products such as the Vanguard FTSE Emerging Markets ETF.. Vanguard declined to comment.

"If the end result of this investigation are rules that say that index providers need to exclude certain China-based companies, then those rules would apply to others" across the industry, Rosenbluth said.

RED-FLAGGED COMPANIES

MSCI and rivals removed seven Chinese companies from global indexes in 2020 because of U.S. ownership restrictions. After Russia's invasion of Ukraine last year MSCI and FTSE Russell removed Russian equities from all their indexes. A FTSE Russell representative declined comment.

The committee's letters this week cited contractors to China's People's Liberation Army it identified in BlackRock funds or MSCI indexes.

Some of the companies have been flagged such as appearing on the U.S. Treasury's "Chinese Military-Industrial Complex" companies list. For companies on it, U.S. persons and asset managers face purchase and sale restrictions but not divestment requirements.

Also, a number of those companies' subsidiaries are still eligible for U.S. investment, at least for now, according to Ritcey-Donohue, even if they are subject to other sanctions like the Department of Commerce’s Military End User list that restricts certain trade with these entities.

(Reporting by Ross Kerber in Boston; Additional reporting by Karin Strohecker in London, Michael Martina and Patricia Zengerle in Washington and Selena Li in Hong Kong; Editing by Megan Davies and Cynthia Osterman)