China Stock Boom Built on Leverage Shows How Fast It Flips

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China’s equity investors are getting a reminder that leverage has a downside.

Losing days on the Shanghai exchange this month have been deeper than at any other time since 2009, punctuated by the benchmark index’s 6.5 percent tumble on Thursday. At 1.65 percent, the gauge’s average retreat on down days this year is the largest among the world’s top 10 markets. It’s also bigger than the mean move of 1.44 percent when the index gains.

While those losses have been easy to overlook as a record 1.34 trillion yuan ($216 billion) of margin debt propelled the Shanghai Composite Index to the world’s biggest gain this year, the use of borrowed money is magnifying market declines.

For Bocom International Holdings Co. and UBS Group AG, the moves are a sign of how forced sales of stock to meet margin calls will deepen losses when the longest bull market in the nation’s history eventually comes to an end. They also illustrate the challenge for Chinese authorities seeking to reduce control over the $9.3 trillion stock market while at the same time ensuring financial stability.

“Such forced liquidation will inevitably create a selling stampede,” said Hao Hong, the chief China strategist at Bocom International Holdings Co. in Hong Kong. He predicts the benchmark index will fall at least another 10 percent before rallying. “For the regulator, it’s a delicate balance between trying to pace the market and curbing fast growth in margin trading.”

Margin Requirements

It was concern about tighter restrictions on margin loans that sparked Thursday’s retreat, the biggest tumble in four months. Changjiang Securities Co. joined larger rivals GF Securities Co. and Haitong Securities Co. in increasing its margin requirement, or the collateral put up by an investor when borrowing to buy shares.

The Shanghai Composite’s drop yesterday was the biggest since a 7.7 percent decline in January, a move that was sparked by a regulatory suspension on new margin accounts at some of the nation’s biggest securities firms. The gauge slid as much as 4.1 percent in early Friday trading, before ending the day down 0.2 percent.

China’s combination of inexperienced investors and leverage is a recipe for volatility, according to Michael-Douglas Lee, a Hong Kong-based trader at SG Securities Ltd.

Downward Spiral

New stock-account openings have surged at a record pace this year, while margin debt on the Shanghai exchange has soared more than 10-fold in the past two years. The Shanghai Composite’s 100-day volatility, a gauge of historical price swings, reached the highest level since January 2010 on Thursday.

Investors “realize that such a bull market can’t continue forever,” said Lu Wenjie, a strategist at UBS in Shanghai. “The problem is that nobody knows when the musical chair game will end. There’s strong herd behavior that exacerbates the downward spiral.”

So far, there are few signs of a large-scale selloff by leveraged investors.

While data on margin trading in Shanghai is released with a one-day lag, the latest figure on Wednesday showed a 0.6 percent increase in the outstanding balance to an all-time high. China’s central bank has cut borrowing costs three times since November to support an economy growing at the weakest pace since 2009.

For Castor Pang, the head of research at Core Pacific-Yamaichi in Hong Kong, this week’s losses show how expensive valuations are spurring investors to sell at the first sign of bad news.

Before Thursday’s retreat, the Shanghai Composite was valued at 18.5 times estimated earnings for the next 12 months, the highest since 2010. The median stock in the index trades at a multiple more than twice that level.

“Confidence of investors is quite sensitive,” Pang said. “Selling pressure is still very high.”

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