A series of monetary easing moves and capital market reforms led to a surge in mainland shares since late last year. However, this was also driven by huge borrowing on margin to buy stocks.
As a result, as China’s markets slide, there is a risk of financial contagion through the unwinding of massive leveraged positions, according to Aidan Yao, senior emerging market economist at Axa Investment Managers.
Of the total RMB3.3trn ($500bn) in leverage, a significant portion is from banks, brokers insurers and shadow banking entities. These financial houses have raised money from instruments like wealth management products and channeled it into a margin financing business, said Yao.
“Some of these institutions also use their own capital and money issued from the bond market to finance the equity-lending business. Further free-fall of the equity market could inflect severe pain on these leverage providers, causing a wide-spread contagion in the financial system,” said Yao.
This could lead banks and financial institutions to cut back on lending due to an increase in bad loans, Yao added.
Craig Botham, emerging markets economist at Schroders said there was a notable surge in the contribution of the financial sector to the country’s GDP in the first quarter.
“This reflects a boom in brokerage businesses, which is unlikely to be sustained in light of current market conditions. This will likely weigh on growth in the third quarter, particularly if efforts to shore up the markets are unsuccessful,” said Botham.
A continuing stock market decline will make it difficult to achieve the 7% annual GDP growth target for this year.
“A final question is whether a stockmarket crash could trigger a hard landing more generally.
“There is an argument to be made that it would undermine faith in the assumed omnipotence of the government in handling the economy, with a potential focus being the rest of the financial system,” Botham added.
Structural reform threat
According to Yao, the Chinese government believed the bull run in the domestic equity markets since late last year could help achieve a number of strategic goals, including financial liberalisation, debt deleveraging and reforms in state-owned enterprises.
These efforts could now be undermined.
“Although some corrections can be tolerated after the stellar rally, the concern is that continued collapse of the market, as we saw in recent weeks, could quickly degenerate into a full-blown crisis.
“Once the damage is done, the equity market could take years to recover – a length of time China cannot afford to lose for its structural transformation,” Yao added.
Botham of Schroders echoed more or less similar views.
“The People’s Bank of China (PBoC) is capable of providing ample liquidity to keep credit markets going,” Botham said.
But providing liquidity will work against efforts to tackle debt sustainability for local governments and state-owned enterprises, and also the recapitalisation of banks.
Market stabilising steps
Chinese authorities have taken a slew of measures over the last few days, which include suspension of IPOs and cuts in interest rates and banks cash reserve requirement ratios.
Moreover, authorities have asked a group of 25 mutual funds to invest in domestic stocks and hold them for at least one year.
The PBoC has also decided to provide liquidity support to the China Security Finance Corporation, an institution that oversees margin financing of brokers, in a move to stabilise markets.
“Among the announced measures, the one that carries the most punch is the one involving the joint operation of the PBoC and CSFC, in our view,” said Axa’s Yao.
“Some market participants called it the big bazooka, as it potentially opens the door for an indirect intervention by the PBoC, via the CSFC.
Yao, however, believes China’s central bank “would not want to risk its balance sheet and credibility by fully committing itself to an equity market bailout”.
Axa Investment Managers continues to have an underweight call on mainland shares.
In mid-June, Blackrock and Morgan Stanley were among the fund houses warning about a potential bubble in China’s equity market.
The Shanghai Composite Index is down about 25% since mid-June:
