* Reforms to be conducted on trial basis initially
* Stock index futures need three more months of preparation
* Large-caps and brokerage stocks will be boosted
* Main risks lie in unfamiliarity with new products (Recasts with securities regulator statement; adds analyst comment, background)
By Zhou Xin and Jason Subler
BEIJING/SHANGHAI, Jan 8 (Reuters) - China has approved in principle the launch of stock market index futures as well as short selling and margin trading of stocks, the stock regulator said on Friday, giving investors badly needed hedging tools.
The reforms, approved by the cabinet in 2008 but delayed by the global financial crisis, will initially be conducted on a trial basis, the China Securities Regulatory Commission (CSRC) said in a statement on its website (www.csrc.gov.cn).
Index futures, which will be traded on the China Financial Futures Exchange in Shanghai, will take about three months to start up, while the trial period for margin trading and short selling will come relatively soon, the CSRC said.
"This is positive news for the market, and it will likely change people's investment strategies," said Huang Yan, fund manager at Guotai Fund Management Co in Shanghai.
A lack of sophisticated tools to manage risks in China's nascent stock exchanges has been a major shortcoming in the notoriously volatile market, which surged 80 percent in 2009 after falling 65 percent in 2008.
Without such hedging tools, investors have had few options to cut their losses in a falling market other than to sell shares -- accelerating the market's decline.
Looking to ease volatility, the government set up the China Financial Futures Exchange in late 2006 to launch derivatives, starting with stock index futures. However, the plan was put on hold because of the mounting financial turmoil around the world.
LONG DELIBERATIONS
Regulators had been deliberating for several years on whether to allow margin trading, whereby investors borrow money from brokerages to buy shares, and short selling, in which they borrow stocks from brokers and sell them in the hope of buying them back later at a lower price.
The changes come none too soon, many analysts have said, as a fresh round of new initial public offerings this year will put downward pressure on the index at the same time that the central bank is stepping up its efforts to tighten liquidity in the financial system.
Stock index futures, considered the most important of the new products, could provide a lift to companies with heavy weightings in the CSI300 Index of 300 local currency A shares traded in Shanghai and Shenzhen, on which the futures are expected to be based.
The average price earnings (PE) ratio of China's 100 biggest listed companies is now at around 15 times of their 2008 net profits per share, less than half the more than 30 times for all Chinese stocks listed on the Shanghai and Shenzhen bourses.
"Index heavyweights are typically not favoured by China's investors and their value has nearly always lagged the overall stock market," said Zheng Weigang, head of investment at Shanghai Securities.
"Once the stock index futures are launched, institutions will undoubtedly increase their positions in large-caps to seek a bigger say in pricing the derivatives. Index heavyweights will then serve as a market stabiliser."
BROKERAGE BENEFITS
The top three spots in the CSI300 are held by China Merchants Bank, Bank of Communications Co Ltd and Ping An Insurance (Group).
Margin trading and short-selling will also benefit brokerages, especially those selected to pilot the schemes, said Guotai's Huang.
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For a SNAP ANALYSIS on the moves, click on:
For a graphic on the top ten weighted stocks in the CSI300, click on: http://graphics.thomsonreuters.com/0110/CN_FTRS0110.gif
For a graphic on how China's derivatives measure up against Hong Kong's, click: http://graphics.thomsonreuters.com/0110/AS_DRVT0110.gif
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Analysts have said that China -- which is moving into derivatives at a time when they are being heavily scrutinized in other countries -- needs changes like the ones announced on Friday to help the market to expand as more Chinese companies venture abroad.
However, some analysts cautioned the changes, even in slow steps, could lead to problems down the road.
"The Chinese investors don't really know how to play this game and that increases the risk," said Patrick Shum, president at BMI Funds Management.
"In the short term there will be an upside, but when the funds and other professional investors withdraw it will leave the retail investors exposed. The market will become more volatile." ($1=6.83 Yuan) (Additional reporting by Aileen Wang and Simon Rabinovitch in Beijing, Samuel Shen in Shanghai and Parvathy Ullatil in Hong Kong; Writing and additional reporting by Lu Jianxin)