China’s stock market is down 42 percent from its 2015 highs. Shares have fallen 16 percent in 2016 so far. But that performance may improve soon.
On Monday, for the first time since last summer’s stock market collapse meltdown, Chinese regulators – via China Securities Finance Corp. – quietly took steps to ease margin restrictions on investors’ use of borrowed funds for stock purchases. That means that they’re going to make it easier – again – for investors to borrow money to buy shares.
China Securities Finance Corp. is like the central bank for Chinese brokerages. Like a central bank, it is a state-backed agency, and it backstops brokerages’ lending (that is, the margin they give investors) by financing brokerages’ margin activity. Without that support, most securities firms would be reluctant to offer margin accounts to their customers.
They stopped offering short-term loans to securities firms last August. This helped get China’s margin explosion under control after the amount of margin being used by Chinese investors skyrocketed. But one byproduct of that was the 42 percent collapse in China’s stock market last year.
During the peak of last year’s Chinese stock market bubble, margin rates were generally set at levels that allowed investors with, for instance, RMB1 million worth of stocks in an account, to buy RMB2 million, or even RMB3 million worth of additional securities.
(Margin buying refers to investors using securities, like stocks or bonds, owned at a brokerage firm as collateral to buy more shares).
So, investors were using borrowed capital to buy more shares. These relaxed margin requirements, that began in August 2014, coincided with the beginning of a record-setting boom that saw the Shanghai Index gain 125 percent over the next 10 months.
Margin buying became so popular, that at the beginning of June 2015, it was reported that total Chinese margin debt was RMB2.2 trillion yuan. That was about 12 percent of the market value of Chinese stocks eligible for margin, and about 3.5 percent of China’s GDP.
According to a report by investment bank Goldman Sachs last summer, that was easily the highest ratio in the history of global stocks markets.
The uninterrupted gains in the stock market made stocks seem like a sure bet. Why not borrow money and buy more? And part of the beauty of it was that as your holdings rose in value, you could borrow even more.
But then the Chinese stock market started to fall last summer. Soon margin lending was restricted as one measure to help prevent more market losses.
That’s because buying stocks with borrowed money works out great as long as share prices are rising. The problems start when stocks start falling. The investor – or speculator – still owes the brokerage firm the money lent to him previously. And as the value of the account falls, it means a higher proportion of borrowed money is now unsecured. This makes the lender, that is, the brokerage, nervous.
If the value of the account falls significantly, the broker issues a “margin call” to demand more cash to offset the broker’s increasing risk.
When faced with a margin call, investors have a decision to make: Deposit fresh cash into their account to satisfy the broker, or sell shares to raise cash and reduce how much they’ve borrowed on margin.
If markets drop quickly and investors get pessimistic, margin call selling can feed on itself – account values fall…so shares are sold to free up cash for the margin call…and all the selling causes markets to fall even more…and on it goes.
We discussed margin calls, and how to escape the forced sale snowball,in a previous article.
Forced selling happened on a massive scale during last summer’s crash, as over-leveraged investors, faced with relentless losses, dumped shares to meet margin payments.
So Communist Party planners, as part of their efforts to bolster a slowing economy, released a margin debt genie from the bottle, which ultimately they could not control.
But after encouraging individual investors to buy shares with borrowed money, Chinese regulators went full circle. That was when margin requirements were tightened to levels that were even more restrictive than they were before the bull market began.
But now they have once again made it easier to invest using margin.
Could history repeat itself? Might the Chinese market be at the beginning of a new bull run because investors have easy access to margin again?
The Communist central planners may want investors to believe so. The recent easing of margin restrictions was interpreted by market watchers as a signal to investors that regulators believe the equity markets have stabilized after last year’s extraordinary volatility.
Could a borrowed money boom-to-bust cycle happen again? Investors – and possibly central planners – have short memories.
If the Chinese market does start another bull run because of the new margin rules, and you want to speculate on it, use an ETF (exchange traded fund). You can buy the United SSE 50 China ETF (Singapore; code: JK8), or the iShares FTSE A50 China Index ETF (Hong Kong; code: 2823).
But be careful. This would be investing on pure speculation, not based on good fundamentals. Remember the last great China market bull run ended in tears. Make sure to watch your stop loss levels… and stay alert.