Trimming the claws of margin financing

Chinese equities have been seeing an outsized bull run. The CSI 300, an index that comprises the largest 300 A shares listed in Shanghai and Shenzhen stock exchanges, surged almost 50% since the start of the year, as of Friday 5 June 2015 .

Electronic board displaying stock quote information at a trading hall in Shanghai, China,
Source: Bloomberg

Over the past year, the index has more than doubled, but it still looks pretty bland compared with the ChiNext, a market for smaller Chinese companies and start-ups, which has tripled in the past one year.

While there are several factors behind the bull market of epic proportions, one particular driver that stood out was margin financing.

Using borrowed money from the brokers to buy stocks was not allowed until March 2010.

Even though margin trading has been around for over five years, it has only recently gain popularity. But once it takes root, the growth is nothing short of phenomenon.

Many retail investors have bought shares using leverage. The amount of margin financing jumped tenfold to CNY 1.41 trillion yuan (USD 227 billion) over the past two years, as of Thursday 4 June 2015, according to the Shanghai Stock Exchange.

The surge in margin trading also coincided with a record number of new investors. We have seen 33 million new A-share accounts opened in the first five months of this year, nearly as much as the previous four years combined.

Debt-financed purchases of stocks in China have soared above 8% of free float capitalisation, over three-times higher than the margin debt level in US, according to research from Macquarie Securities Group.1

To be sure, a stock market rally on the tailwind of highly-leveraged financing is akin to constructing a building on sand. The foundation will be shaky. Seismic shifts in price direction would happen with a quick change in sentiments, particularly with an estimate of retail investors accounting for 80% of the trading volume.

We have seen huge fluctuations this year, which would have made most retail investors white-faced. Even the Chinese regulators have repeatedly trotted out warnings of risks.

Lately, brokers across China are tightening rules on margin lending to limit the risks from any market collapses. More importantly, what regulators want to do is curb excessive speculations. Changjiang Securities, GF Securities and Haitong Securities raised margin requirements, while Southwest Securities reduced the amount of margin financing that investors could get using collaterals.

Meanwhile, Nanjing Securities said it would impose restrictions when the market value of a single stock accounted for over 70% of a client’s margin finance account.

The changes to margin trading were a reminiscent of related moves in January, where the Chinese securities regulator banned several large brokerages from opening new margin financing accounts for three months. The regulatory action dragged the Shanghai Composite to its largest one-day drop in six years. Likewise, the recent changes spooked retail investors, which saw Chinese equities suffer a heavy loss.

Naturally, these sharp pullbacks prompted the usual round of correction calls, but it is rather plain to see that the Chinese markets remain decidedly bullish on the whole. Increasingly tighter regulations around margin financing should be seen as a longer-term positive development for the stock market. This feeds into the idea that while Beijing wants higher stock prices, they prefer a healthy capital market.

Tellingly, the People’s bank of China (PBOC) did not address potential dangers about the country’s surging equities in its 2015 financial stability report, saying only they will promote a stable and healthy stock market.

Certainly, increased regulations in margin trading will induce large volatility in the short term, but looking at the bigger picture is more pertinent. The strong rebound in Shanghai Composite on the first day of June served to illustrate the importance of having a longer-term view, instead of being overly-fixated on short-term tremors.




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