A boom in margin lending in China that has helped fuel a bull run in stocks is continuing despite official attempts to rein in borrowing. But the measures taken so far are easily sidestepped, creating volatile market conditions while doing little to stop investors chasing leverage.
In November 2014, China's central bank announced a surprise interest rate cut. Although designed to deliver more credit to the real economy, the result was to trigger a surge in share prices. The Shanghai Composite Index rose by 51% between Nov. 20 and June 5, when it hit 5023.1.
By July 2, however, the index was back to 3912.77 -- a fall of 22.1% from the November peak. Many commentators have blamed the fall in prices on official action against margin lending by stockbrokers, but it is investors using more highly leveraged shadow margin lending who are seeing their positions liquidated.
The underlying causes of the bull run lie in China's slowing pace of economic growth and a downturn in the property market, which together have reduced demand for money to invest in the real economy and encouraged investment in financial assets such as shares.
As stocks rose, demand from investors for borrowed funds to buy shares pushed the outstanding volume of loans from mainstream financial institutions for share financing to more than 2 trillion yuan ($323 billion) by the end of May, or about 3% of gross domestic product. This compares with around 500 billion yuan at the start of September 2014.
Much of the credit involved is margin lending, traditionally extended by stockbrokers, where borrowings are secured against an investor's asset portfolio. If the value of the portfolio dips below an agreed proportion of the credit extended, the borrower will face a "margin call" and must either repay the loan or top up the portfolio with additional funds. Failure to do so triggers the sale of the assets at prevailing prices to repay the loan.
The prevalence of margin lending worries the China Securities Regulatory Commission, which fears that some investors do not appreciate the risks they are running, especially in relation to shares bought at inflated valuations. By June, the median stock on Chinese exchanges traded at a price-earnings ratio of 58 -- triple the level in the U.S. and Japan.
However, the CSRC is wary of taking action that might precipitate a crisis by cutting off the supply of credit in a way that would undermine share prices. Its preferred course has been to try to temper the growth rate in margin lending, but to avoid quashing it entirely.
According to the latest rules issued in June, margin lending by brokers has been for the first time limited to up to four times net capital, capping overall market risk. However, this will not stifle the margin lending business since even the largest lender, Guangfa Securities, still has room to double its financing of customers' share purchases. In any case, the new rules also allow brokers to roll over margin loans, which were previously limited to six months in duration.
Easy, but risky
The truth is that the regulator wants to ensure that investors seeking leverage keep borrowing from brokers. This is because it knows that if investors are turned away by brokers, the so-called shadow banks are more than ready to fill the gap with loans that are easy to get, but much more risky.
Unlike traditional banks, shadow banks do not take deposits to fund loans, do not have access to central bank emergency financing or safety nets such as deposit insurance, and are largely unregulated. The sector includes money market and private equity funds, hedge funds, and institutions such as investment banks and mortgage brokers.
For investors seeking to borrow on margin, shadow banks have a number of advantages, including offering higher leverage of up to five times portfolio valuations, compared with an official limit of twice portfolio valuations through brokers. They also allow borrowers more freedom in buying shares, rather than insisting on a detailed margin lending program.
Typically, shadow banks pool clients' funds under so-called "umbrella trusts," which also include borrowings from traditional banks. The banks receive fixed rates of return on their funds, and get indirect exposure to the stock market, enabling them to bypass restrictions on investing directly.
The shadow banks lend the funds they have raised to investors at a higher rate, earning the interest rate spread. The investors receive details of a sub-account and a password allowing them to invest via HOMS, a popular trading system. They can then trade with leveraged funds and take any capital gains, or losses, on the account.
There are no official figures on the extent of investment funded by shadow banks, but commentators have estimated that margin lending by trusts has pushed between 500 billion and 1 trillion yuan into the stock markets, in addition to the 2 trillion yuan provided through mainstream lending channels. Analysts at Fenglian Finance believe the higher figure is probably about right.
It seems unlikely that this flow of funds into the market has been stopped. The shadow banks do not believe that the regulator is serious in seeking to reign in margin lending, arguing that the CSRC could have achieved its objective long ago by introducing more stringent restrictions, but has not done so because of the risk of massive losses among ordinary Chinese.
Even if it wished to crack down on margin lending by shadow banks, the regulator would face serious practical problems. Typically, the funds are held under the trusts' main accounts at their brokers, which means that the CSRC is unable to identify shadow margin lending activity in the trusts.
In any case, margin loans are issued under personal names, perhaps those of directors or partners in the shadow bank, rather than in the names of the companies involved, which is legal but disguises the source of the funds.
Cat and mouse
In May, the China Banking Regulatory Commission, the banking regulator, tried to cut off the flow of money to shadow banks by banning traditional banks from lending to umbrella trusts. But this has yet to stop the cat and mouse game. A simple workaround allows the shadow banks to set up the same cash flow through a single trust instead.
Margin ratios of 1:5 can still be found by investors borrowing from shadow banks with diversified liquidity sources, which continue to include liquidity from banks, plus funding through peer to peer lending platforms, or idle funds from large corporations such as state-owned enterprises and property developers. All these potential sources of funds are chasing higher yields in the face of slowing economic growth. The only threat to this business would be investor sentiment turning bearish.
If the regulators genuinely wished to halt shadow bank margin lending, they could certainly do so. However, significantly more robust action would be required, and there would be a risk of disrupting normal market operations. For example, investment in the stock market by trusts could be banned, as could trading in HOMS using sub-accounts. Either course could trigger panic selling and a painful market crash.
A wiser approach would be for the government to let shadow banks play a greater role in China's financial reform. Despite more than 30 years of opening up and reform, the financial system is still dominated by the state banks, which prioritize state owned enterprises at the expense of private enterprise and personal customers. Shadow banks exist to fill these service gaps.
When the bull run ends and investors realize that they cannot rely on share prices moving inexorably upwards, in spite of market fundamentals, the shadow banks will have new and more sophisticated products lined up to keep their clients' funds in motion. This is a painful but necessary adjustment process in China's financial system development.
Shadow banks that set up basic margin lending operations have already hired experienced industry professionals, invested in trading technology, and improved risk management practices. These investments combined with retained profits and a client base from the margin lending business could be used to build a platform creating new financial products.
This approach would synchronize neatly with the government's desire to boost financial innovation and widen investment choice. The government needs to provide more investment choices to prevent bubbles from developing in specific asset classes -- this has happened in property in the past, and is occurring in equities now, in spite of the recent falls in share prices.
Overall, embracing the shadow banks would help the government achieve its reform goals more quickly, and would create a more efficient market than is possible through the subsidized state players. It would also help stem rising capital outflows, which risk destabilizing China's economy, by keeping the funds flowing within China's domestic financial sector.
Christopher Aston is a cross-border finance manager in Hong Kong with Fenglian Finance, and author of the blog chiecon, which translates material on China's economy.