* 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)

By Noah Sin and Krishna N. Das

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.