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China's equity market faces new peril from pledged shares

Sell-off threatens to drive more investors away in vicious cycle

Retail investors have led the current sell-off, which could force lenders to sell their pledged-share holdings and drag the market down further.   © Reuters

SHANGHAI -- Widespread share-backed lending in China threatens to worsen its bear market if plunging prices prompt lenders to dump stock held as collateral, a trend that could dampen consumer sentiment and further weaken the domestic economy.

The Shanghai Composite Index closed down 0.9% Tuesday at 2,504, after breaching the year-to-date low of 2,486 at one point. About 80% of all shares suffered a decline.

"Retail investors are panic-selling," said a manager at Chinese brokerage Industrial Securities.

Retail investors are responsible for 80% of stock trading in China, and tend to heavily influence the market in one direction or another. "The market won't bottom out until the Shanghai index falls below 2,000," a 30-year-old man who makes his living from stock investments said outside a Shanghai brokerage.

Reports that U.S. Treasury Secretary Steven Mnuchin called heads of top American banks also fueled selling in China, where there is little confidence in the financial system.

"Dialogue between the financial authorities and financial institutions can easily be taken here as a sign that operations are not sound," said a Chinese securities company.

With the Shanghai index's closing near the 2,500 mark, concerns are growing about pledged shares. It has become increasingly common practice in China for big shareholders to use their stake as collateral for loans.

There were 637.1 billion shares pledged as collateral in China as of Friday, up 12% from the end of 2017 and roughly triple the amount in January 2015, when the country was entering bubble territory. They are valued at 4 trillion yuan ($580 billion) and come from 3,400 different corporations.

Nearly 150 companies are believed to have over half their shares tied up as collateral. Major names with high rates of pledged shares include TCL, China Minsheng Banking and real estate group Greenland Holdings. The scheme has given their major stockholders access to more capital, fueling greater investment and expensive purchases.

In China, lenders can sell collateral shares once their price falls below a predetermined level corresponding to the size of the loan, usually about 30% to 40% of their market value at the time of contract. A significant number of companies are said to have breached this line as the Chinese market continues its long decline since peaking in mid-2015.

"The value of shares that could be sold by financial institutions is about 700 billion yuan," said an official at the China Securities Regulatory Commission.

The commission has urged financial institutions since early autumn to keep liquidity ample for borrowers, but a fundamental solution has not emerged.

The global stock sell-off has not abated either. The Nikkei Stock Average closed down 5% on Tuesday at 19,155, falling below the key 20,000 mark for the first time since September 2017.

The Dow Jones Industrial Average also finished 2.9% lower Monday for its worst Christmas Eve since the index began in 1896, according to S&P Dow Jones Indices. Markets have been rattled as the Federal Reserve and European Central Bank tighten their monetary policy, in addition to turmoil within the administration of U.S. President Donald Trump.

Rising interest rates are prompting investors to move money out of risk assets like stocks and oil and into bonds from developed countries. Market watchers maintain a wary outlook for 2019, and the flight to safer assets could last for some time.

Money from overseas, which has underpinned Chinese markets in the past, is expected to slow as well. Although buy orders came in toward the end of the Tuesday session from what appeared to be government funds, few are predicting a true rally.

"China and the U.S. need to ease their tensions, which are weighing on their economies," said a Chinese securities company.

The Chinese is economy is decelerating at a faster pace, with retail sales growing just 5% in real terms. The slowdown has contributed to declining stock prices, which in turn is dragging down big-ticket purchases in a vicious cycle. Car sales in China have also continued to shrink since the Shanghai index fell below 3,000 in July.

Nikkei senior staff writer Yusuke Matsuzaki in Tokyo contributed to this story.

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