China’s A-share support heightens contagion risk

Author: Ashley Lee | Published: 10 Jul 2015
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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 still.

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 finance products.

'Investors could sometimes multiply leverages allowed by both regulated and unregulated products to achieve a much higher overall leverage,’ wrote Liao.

KEY TAKEAWAYS

  • 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 inflated;
  • This could affect bank and brokers’ balance sheets, and change the government’s plans to move towards a market-based system

Contagion risk

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 being."

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 volatile.

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 banks.

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.

Looking ahead

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 markets.

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.

See also

A-share lock-ups hinder PE exits

US rule of law blocks trump China

Banks must adapt as RMB reform quickens