China Threatened By "Vicious Circle Of Panic Selling" From Marketwide Margin Call

Two weeks ago, when commenting on the PBOC's latest required reserve ratio cut, we pointed out that one of the more prominent risks facing the Chinese stock market, and potentially explaining why the Shanghai Composite simply can't catch a bid during the recent rout, is the risk of a wave of margin calls resulting in forced selling of stocks pledged as collateral for loans.

The pledging of shares as loan collateral - a practice that has gotten increasingly more popular over the years - has been especially prevalent among smaller companies as we observed in February and initially, last June. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds.

Here, the risk for other shareholders is that when major investors take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble, and are forced to liquidate stocks to repay the loan. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors was likely a key factor.

Small caps aside, the marketwide numbers are staggering: about $1 trillion worth of stocks listed in China's two main markets, Shanghai or Shenzhen, are being pledged as collateral for loans, according to data from the China Securities Depository and ChinaClear. More ominously, this trends has exploded in the past three years, and according to Bank of America, some 23% of all market positions were leveraged in some way by the end of last year in China, double from the start of 2015.

Source: WSJ

As a result of the recent market rout which sent the Shanghai Composite into bear market territory, in June UBS warned that it sees a growing risk in China's stock pledges; the bank calculated that the market cap of pledged stocks that have fallen below levels triggering liquidation amounts to 440 billion yuan with some 500 billion yuan below warning line, which translates to ~1% and 1.1% of China’s entire market value of $6.8 trillion. A separate analysis by TF Securities, as of Jun 19th, stock prices of 619 companies were close to levels where margin calls will be triggered. Since then, that number has increased.

Now, a new analysis by Morgan Stanley looks at the threat rolling margin calls pose to China's brokers, who are the intermediaries most exposed to stock pledged financing and over-pledging.

According to the bank's own analysis, shares pledged account for ~10% of total A-share market cap, with 123 companies over 50% pledged, amounting to a combined pledged market cap of RMB1.0 trn, or 2% of total A-share market cap.

Furthermore, so far in 2018, there have been ~50 A-shares that have suffered price declines over 60%, with an average pledge ratio of 28%, thus likely falling below margin closeout level. According to the Securities Association of China, stocks below margin closeout level amounted to <1% of total A-share market cap as of June 26.

So what does this mean for brokers?

Morgan Stanley estimates that the total stock pledged financing balance at ~RMB2.7trn, of which RMB1.6trn is by brokers. The good news, is that following the introduction of new asset management rules in China, and ongoing financial cleanup, banks' participation has been notably less, since this falls under non-standard credit assets.

The not so good news is that even with regulatory changes, as of end-2017, brokers' stock pledged repo exposure was equivalent to more than all of the brokers' net capital, or 103%, up from 16% in 2013.

Putting these numbers together, Morgan Stanley calculates that it would take ~11% of brokers' net capital to absorb 50% of their exposure to stock pledged financing below margin closeout level.

But how great will the pain for brokers get if the market continues to slide?

That is the question Chinese regulators tried to answer earlier in the year when the awoke to the threat of China's stock-pledged financing, additionally realizing that compared to margin financing or OTC leverage, stocks used for stock pledged financing are less liquid, as major shareholders' stock holdings could be locked up or subject to shareholding reduction restrictions.

Which brings us to the new rule on stock pledged repo business implemented on March 12, 2018 which enforced stricter standards on concentration and collateral, and the Notice on June 1, 2018 essentially suspended OTC stock pledged financing for brokers.

Meanwhile, to ease concerns about margin calls, regulators set the guarantee coverage ratio as 181% for SHEX and 223% for SZEX, still relatively sufficient, if well below the initial levels of ~300%. And, as Morgan Stanley adds, in an attempt to avoid a feedback loop, regulators advised brokers to avoid margin closeout and provide liquidity support by extending contract periods or negotiating for more collateral.

In short, as prices drop ever lower, Chinese regulators are stretching the rules hoping that the current wave of selling ebbs and prices rebound from levels that would have already triggered forced liquidations. Or, as Morgan Stanley writes, China is doing everything in its power "to maintain stability of capital markets and avoid a vicious circle of default and panic selling, causing markets to spiral down further."

What is perhaps most concerning for Beijing regulators, is that despite all its efforts to prevent self-reinforcing liquidations, the Shanghai Composite has continued to sell off despite all its best efforts, and worse, the trade war with the US which has emerged as a major risk for Chinese companies comes at a time when the Composite is on the verge of taking out a critical support level: the lows hit after the bursting of the 2015 Chinese stock bubble.

Which may also be the line in the sand for China, and should the Composite slide another 100 or so points, taking out the critical support at 2,655, then regulators may finally be forced to tap banks and brokers on the shoulder, and demand companies repay loans. The resulting stock mass liquidation could also be the trigger Trump needs to demand capitulation from Beijing as part of the escalating trade war. The big question is, if indeed this is the endgame, whether China will allow this to happen without retaliation, or if Beijing - having little to lose - will sell a few hundred billion Treasurys to punish US capital markets as its own stock market crashes and burns.

Comments

Baron von Bud Sirius Wonderblast Sat, 07/07/2018 - 22:25 Permalink

Well folks, now you see the effect of Trump's trade tirades against China. Create a loss of confidence among leveraged investors. It's an economic war with China. If there's a huge selloff and panic, guess who will be ready to lend a hand - the crony US/Euro banks. China opens the market to foreign shareholders in exchange for capital inflows and equity ownership. That's how a war is played in the 21st century. But I think China already war-gamed this. Watch out.

In reply to by Sirius Wonderblast

gdpetti Baron von Bud Sun, 07/08/2018 - 11:14 Permalink

Well, they want to release the pressure in their over priced market... and our Fed seems to want to do the same, only the message hasn't sunk in here yet. With China, you don't have the extra layer of political/economic BS... the East has always been more 'up-front' in this regard, while the Western oligarchs have always pushed for front men/women to give the masses an illusion of 'democracy', freedom etc... all of which has been long played in the fake elections.. puppet show theatrics, but nothing much ever changes, does it? the wars, the regime changes, the financialization, the crimes, etc.

China is following in our footsteps, but seeks to parry away some of the downdraft when our markets are allowed to crash... it's best to be first and ready for the future... which is why Xi has been doing so much 'cleanup' work in the Party and in recent years, in the markets as well....how to encourage the process without losing control.

There is an article posted today on top of this website on President Roosevelt/berg as the Architect of Monetary Madness with his regimes' manipulation of the PMs, which affected China as well, which helped push the Communists in China, as Chang's nationalists were too corrupt and stupid to deal with any of it... so it all can be seen in the bigger picture of how the 'game' is played here in 'purgatory'... how the SG setup and run these contests between nations.... how they manipulated the masses etc.

In reply to by Baron von Bud

divingengineer Winston Churchill Sun, 07/08/2018 - 19:28 Permalink

Don’t think they got much us debt left, why do you think Trump decided to move on them, they got no recourse.

Their big threat is that they’ll quit letting our food in.

Food is the most valuable thing in the world, with the possible exception of clean water.

Theyre in a panic, up shit creek, they’re losing their parasitic host and they are losing their shit over it.

Gonna be funny as fuck watching this play out.

In reply to by Winston Churchill

MuffDiver69 Sat, 07/07/2018 - 19:13 Permalink

Damn...I read the article two weeks ago related to this and this really is some fantasy land crap...I hope they do sell...we need to take this pain now and get the hell away from these dog eaters...

Captain Nemo d… Sat, 07/07/2018 - 19:50 Permalink

Stocks pledged as collateral for loans is just part of a great efficient and liquid market for everything. Can you use the loan to buy back your other stock and then with the price rising on the news of the buy-back, sell enough stock to pay off the loan?

MrNoItAll Sat, 07/07/2018 - 21:50 Permalink

If the Chinese do sell a few hundred billion Treasuries to "punish US capital markets", who will be the buyer of that few hundred billion? ECB? Japan? The FED itself? WHO!!?? And wouldn't selling all those Treasuries turn into a major loss for China? Answers anyone? In any case, if the Chinese stock market crashes and burns, selling treasuries will be the last thing Chinese leadership has on its mind. The more immediate concern will be riots in the streets. And the rest of the world will be burning too. Getting closer and closer...

William Dorritt MrNoItAll Sun, 07/08/2018 - 14:27 Permalink

If the China House-of-Fraud burns to the ground, so what.

They can dump their Treasuries at a loss and use the dollars to purchase some Russian oil and gas, for about 6 months. I'm sure Putin will accept dollars and Gold over RMB.

They can take the products they sell to the US and sell them to Cuba, Venezuela, and Iran..... their new markets; and, accept Venezuelan, Iranian and Cuban currency which aren't even convertible into a pile of dog shit. Will Russia accept Bolivars for their oil ?

Perhaps Merkel will open her arms to the Chinese products and throw 20% of Germans out of their jobs to save her Marxist Comrades, the Silk road can bring millions of sex-tourists to Germany to fill the unemployment gap created by her latest policy. High speed trains running from China directly to Berlin, think of the convenience. Unlike Merkel's Islamic Hoard, at least the Chinese sex tourists would pay for it. China is short about 100 million women as a result of Commie mismanagement and bias against females at the abortion mills in China.

China can have NK threaten a Nuke launch at Japan, who just finished installing $100B of US weapons with another $100B on the way. Is NK really going to risk getting vaporized so China can sell toxin-laden low-quality products through ChinaMart and ChinaZon ?

For anyone not awake, Japan and probably Taiwan could become Nuclear powers in about 15 days if they wanted to, they already have the ballistic and cruise missiles to deliver up to 1500 miles.

In reply to by MrNoItAll