A quest by Chinese authorities’ to curb a market selloff seen since mid-June took a major hit on Monday as the Shanghai Composite Index and Shenzhen CSI 300 Index plunged 8.5 percent, which was the worst daily loss since February 2007.
But the losses could get worse.
Chinese stock markets will continue to see ‘relentless selling’ which is likely to have a ‘profound effect’ on its economy and its financial system, according to Bank of America.
Following Monday’s stock rout, China’s securities regulator said that it was prepared to buy shares to stabilize the stock market and avert “systemic risks”.
The regulator also said that market authorities would deal severely with anyone engaged in the “malicious shorting of stocks”, in Beijing’s most recent attempt to avoid a full-blown market crash.
In China, waves of new investors buying stocks on margin fueled a surge in its equities, which skyrocketed 152 percent over the past twelve months through June and rose nearly 60 percent on the year through June 12 where a 52-week high was reached and marked the first time that the market capitalization of Chinese stocks had rose above $10 trillion.
Such steady flows of margin lending made Chinese regulators very nervous, and as a result, they tightened rules on the amount of margin financing that brokerages were allowed to extend by capping at around two to three times investors’ initial capital.
As of the end of June, Chinese brokerages had extended 2.1 trillion yuan ($339 billion) worth of margin loans to investors, according to Bloomberg.
Image courtesy of Bloomberg
However, this actually understates the full extent of the leverage, as Bank of America believes that leveraged bets on Chinese stocks are actually more than double what you might expect.
Image courtesy of Bank of America
“We estimate that margin outstanding, only from the seven channels that we can estimate reasonably, easily exceeds 3.7 trillion yuan,” Bank of America strategist David Cui wrote in a research note. “Assuming an average one times leverage, it means that at least 7.5 trillion yuan market positions are being carried on margin, equivalent to some 13 percent of A-share’s market cap and 34 percent of its free float.”
“Although in theory the borrowers can use the obtained funds for many purposes, we suspect that in recent times most of them used the funds to invest in the stock market, sometimes by buying the very stocks they used as [collateral] to drive up their prices,” he writes.
But the surge in Chinese equities quickly came to an end as investors started winding down their margin positions and Chinese stocks fell into a bear market on June 29 and continued crashing as the Shenzhen Composite Index fell 40 percent through the peak crash.
As markets continued to fall, Chinese companies rapidly suspended trading, one after another, until there were trillions of dollars frozen from trade.
According to Bloomberg, on July 7, nearly 75 percent of traders were frozen from selling their shares of Chinese stocks during the crash.
When all was said and done, at the time, there was nearly $4 trillion dollars wiped out from the Chinese market.
Cui believes that the practice of margin lending was what largely drove the paralysis of many stocks while Chinese equities were crashing.
“It appears to us that potential margin calls from this lending source is one of the main reasons why, at the height of the A-share market crash, close to half of the A-share companies had their stocks suspended from trading,” Cui writes.
Following the market crash in China, a wide array of urgent measures by Chinese authorities were implemented in order to stabilize the market, such as an interest rate cut (the fourth cut in seven months) to a record low, relaxing of margin lending rules, suspending initial public offerings (IPOs) indefinitely, setting up a market-stabilization fund, having its top 25 mutual fund houses speed up the application and issuance of equity funds, and various other tools. However Cui doesn’t believe that the measures taken to date will be sufficient, as all the leverage “means relentless selling pressure.”
Such heavy selling, he observes, has the potential to trickle through to China’s real economy:
It seems to us that A-shares ex. banks could at least halve, which would only bring down their average PER [price-to-earnings ratio] to just below 20x, before any reasonable case about valuation support could be made. This means that most leveraged positions may suffer from losses ultimately, likely in Rmb trillions. … Banks’ capital may suffer greatly as well once the equity of the other [financial institutions] is depleted – banks provide or channel most of the leverage directly or indirectly. The risk is that the unwinding of the leverage will be disorderly – due to implicit guarantees behind most shadow banking financial products, investors could easily panic if they suffer from meaningful capital losses, by our assessment. The key risk to our view is that the government may be prepared to take on substantially all the leverage, in which case, we expect RMB or growth to come under pressure.
Either way, the strategist concludes, “what just happened in the A-share market will likely have profound impact on China’s economy and financial system.”
Oxford Economics recently said that China could be the next country to join the zero interest rate club in another effort to boost economic growth, which it estimates is actually running at a pace closer to 4 to 5 percent, well below Beijing’s official estimate of “about 7 percent” growth. However Oxford said that even zero rates may not be enough to spark the economy, and other policy action such as monetary-financed deficit spending might be needed.
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