The government’s support of its
equities markets following a precipitous drop has exposed
increasing risk in its financial system
China’s stock markets have plummeted
30% in the past three weeks, and the government unleashed a
slew of aggressive – and unprecedented –
measures to support them.
So far regulators have suspended IPOs and barred shareholders holding more than a five
percent stake in a company selling shares for six months.
People’s Bank of China (PBOC) has given the China Securities Finance Corporation
CNY 260 billion ($41.9 billion) to provide to brokerages to buy
shares. And on Wednesday more than half of the companies in
Shanghai and Shenzhen had suspended trading.
David Cui, head of China equity strategy at Bank of
America Merrill Lynch, believes that unless the government
keeps pushing the market up, the selling pressure would likely
stay relentless because of leverage.
While it’s difficult to come up with
an accurate estimate, Cui said up to one-fifth of the A-share
market’s free float is carried between
over-the-counter and official margin lending.
"The problem is the market has to keep going up for
these positions to break even due to high margin financing
costs," said Cui on a media call today.
He compared the situation to how a shark has to
keep swimming to breathe; that’s similar to this
market, he added, because it has to keep going up to stay
In a July 9 note, Standard & Poor’s analyst
Qiang Liao described the so-called umbrella trust as the most
cited unregulated margin-financed product. It is a structured
product that investors can use to achieve higher leverage
– often four to five times – than the
conservative caps set by securities firms for regulated margin
'Investors could sometimes multiply leverages
allowed by both regulated and unregulated products to achieve a
much higher overall leverage,’ wrote Liao.
- China’s government has supported its
equity capital markets after they lost 30% of their value in
the past three weeks;
- But many of the gains were fuelled by margin
financing with expensive collateral – especially
since that collateral’s value was
- This could affect bank and brokers’
balance sheets, and change the government’s
plans to move towards a market-based system
As brokerages and banks are being called on to
bolster the stock market, investors have immediately focussed
on financial institutions’ balance sheets. Cui
predicted that there will be a significant amount of write-offs
related to margin financing, especially since brokers and banks
have been the largest sources of financing in this space.
However Standard &
Poor’s announced yesterday that its ratings on
brokerages CITIC Securities and Haitong Securities are
unaffected. In the July 9 note, Liao said: "We believe
contagion risks from the sharp fall in China’s
equity market to the rest of the financial system and the wider
economy remain manageable, at least for the time
Cui believes contagion risk
remains high. The chances of financial crisis have risen
considerably, and the timeline has most likely been brought
forward, he said.
While the markets were already
aware of high leverage in China, the sudden surge in the stock
market added even more in the system. "The new leverage is a
particularly dangerous form of leverage because the collateral
value is inflated," he said, adding that the stock market
remains expensive and collateral value is still very
The opacity of the Chinese
financial system and the lack of a clear definition of risk
responsibility doesn’t help.
The relationship between margin
lending and shardow banking is a salient example. One of the main types of credit intermediation in China
outside the traditional banking system is wealth management
products (WMPs), which are off-balance sheet, informally
securitised loans sold by financial institutions;
they’re often described as the shadows of the
And these products may have funded
margin lending, which means that managing losses is especially
tricky for banks.
If banks take losses onto their
balance sheets, their equity is impaired. But if they pass on
the WMP losses to investors, they could potentially destabilise
the shadow banking sector; banks, brokers and investors will
need to figure out how to distribute these losses.
One of the painful lessons from this market is that
even the Chinese government can’t defy gravity,
according to Cui. "You can’t push up markets
without living with the consequences."
Its intervention has also damaged the A-share
market’s reputation; international investors will
be more sceptical about investing in the future as the market
isn’t driven by fundamentals. In contrast, the
Hong Kong Exchange insisted it would not interfere with its
More broadly the crash could also change the
government’s plans to move to a market-based
approach. "I think the deregulation, in hindsight, progressed a
lot faster than what the regulators can handle," said Cui.
A-share lock-ups hinder PE exits
US rule of law blocks trump China
Banks must adapt as RMB reform quickens