Index provider FTSE Russell will retain China's onshore government bonds on a watchlist for a possible upgrade that could allow Chinese debt entry to its widely-tracked government bond index.

Malaysian bonds, which were on review for a downgrade that would have excluded them from the World Government Bond Index (WGBI), were also retained on the watchlist, giving the Southeast Asian country six months to try and improve liquidity so that it avoids a damaging eviction from the index.

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 is the most foreign-owned 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.

The Malaysian ringgit firmed 0.05 per cent against the dollar to 4.191 as of 0224 GMT (10.24am Malaysian time). Analysts said markets will next focus on the country's budget to be presented on Oct 11.

"FTSE Russell will continue to engage with market participants to understand the practical impact of recent initiatives announced by Bank Negara Malaysia (BNM) to improve market liquidity and accessibility," the index provider said on Thursday, referring to the country's central bank.

Last month, Bank Negara 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 the central bank had a "very positive engagement" with FTSE Russell about Malaysia's status on its government bond index.

"The liberalisation measures taken thus far are likely working but haven't sufficiently crossed the hurdle to completely take Malaysia out of the watchlist," Malaysia's Maybank Kim Eng said in a note.

"We think there could be more follow-up measures by BNM on fine-tuning of policies."

BNM did not immediately respond to a request for comment.

Maybank said the overall impact on the bond market was expected to be neutral, while Malaysian investment bank MIDF said it expected the ringgit to gradually appreciate against the dollar towards the end of the year.

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

Overhanging concerns of potential foreign outflows are "a negative to the market" due to the extended period of uncertainty, according to AmInvestment Bank.

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

Foreign holdings in Malaysia's bond market were about US$157 billion (RM658 billion) in July.

Malaysia's 10-year sovereign bond is the benchmark issue most widely tracked by foreign investors.

On China, Maybank said investors have noted measures taken by the country to open up its onshore bond market but they want further improvements to secondary-market liquidity and flexibility in foreign exchange execution and the settlement of transactions.

- Reuters