Encouraged by the State, Chinese Put Everything at Risk With Margin Trading

How the regime encouraged its citizens to buy stocks with borrowed money.
Encouraged by the State, Chinese Put Everything at Risk With Margin Trading

China’s stock bubble is bursting, and millions of ordinary Chinese are about to lose their shirts. Aside from the obvious pain that losing one’s life savings would incur, what makes this market crash unique is that the Chinese Communist Party created and encouraged it.

Heading into the New Year, China was facing one of the worst economies in recent times. Repeated downgrades in growth and market instability in the last year have shocked global markets used to meteoric China growth, and struck fear into the regime, which relies on that growth to maintain social order.

The Party thought that a rising stock market would be a good way to raise confidence in its economy. It could alleviate companies’ financing crunch, enrich investors, serve as a distraction for the unemployed, and allow local governments and banks to refill their coffers.

The Party’s methods worked for a while. The number of new brokerage accounts that opened in the first four months of 2015 was more than 2012 and 2013 combined.

What it did was rally and encourage its citizens to invest in stocks.

First, it loosened regulations, making it easier to borrow money for investments. Second, it appealed to its citizen’s patriotism and desire for wealth by directing the media to publish commentaries extolling the virtues of buying stock as a way to get rich while supporting the regime. “Economic and social development will bring precious confidence and strong support into the stock market,” read a line from an editorial in Xinhua published Aug. 31, 2014.

On Nov. 28, 2014, the average daily turnover on the Shanghai Stock Exchange exceeded 200 billion renminbi ($33 billion). Six months later, in late April of this year, daily turnover was up to $161 billion. The Shanghai Composite Index, the stock market index of all stocks traded on the Shanghai Stock Exchange, more than doubled in the last year.

But that growth was fueled by ordinary Chinese with very little financial experience—farmers, pensioners, factory workers—who had yielded to their leaders’ calls to invest, and who in turn expected to be protected by the Party from harm.

Today, these new investors are crowded at brokerage firms watching the trading screens with horror, according to a CNBC report from Beijing. 

“The government has been manipulating the stock market all this time,” one investor who didn’t want to be named told CNBC. “The authorities made us believe that we can make money from a bull market but actually we are falling into an abyss losing most of our life savings.”

Borrowed Money

Things really changed when Chinese regulators introduced and encouraged the risky instrument of margin trading as part of its larger effort to open up markets and divert investments away from real estate, where speculative investment had reached unreasonable proportions. As recently as 2007, Chinese stock regulators forbade leveraged trading—and for good reason.

The practice of margin trading gives ordinary Chinese access to money they wouldn’t have otherwise had to invest in stocks, allowing for trading on borrowed money.

Spurred on by the Communist Party’s robust media propaganda machine, nearly 5 million retail investors had opened margin accounts by October 2014, up from fewer than a million accounts two years prior. In recent months margin-trading volume hit repeated volume records.

“Over a quarter of China’s stock market capitalization is now supported through margin financing, turning an equity market into a de facto debt market,” according to a post by Scott Kennedy, a China scholar with the nonpartisan Center for Strategic and International Studies (CSIS).

With such a significant share of the market, any instability in margin trading will have a significant impact on the overall market. In early July, the Shanghai Composite Index demonstrated extreme volatility when it fell 7.7 percent—the biggest drop in more than six years—after a temporary crackdown by authorities on three large brokers dealing in margin trading.   

Margin trading is high-stakes, high-risk trading. If an investment suddenly fails, speculators could lose not just their money, but any assets that were posted as collateral for the margin loan too.

The Party’s Answer: More Leverage

When the stock market began to plummet, China’s leadership turned to the China Securities Finance Corp. (CSF), to be the conduit for the China central bank to intervene and inject money into the market. The CSF, established in 2010 with approval from China’s cabinet the State Council, is the only institution providing margin financing loan services to brokerages that sell margin stocks.

The Party has also tried other measures, but nothing seems to have had much impact in stemming the flow of panic-ridden investors from fleeing stocks. There have been interest rate cuts and the use of government pension funds to prop up the market.

“We have the confidence and capacity to cope with all manner of risks and challenges, and to advance sustained, healthy economy development,” Premier Li Keqiang said to a gathering in Beijing, according to Xinhua, the official news agency.

At the same time, some of those ordinary investors are questioning why their leaders are not doing more. “I’m sure if the Chinese Communist Party is really determined to rescue the market, they could turn it around overnight,” said an unnamed investor in Beijing, according to CNBC.

In early July, much anticipated new policies were hastily released by Chinese authorities. Their answer: allow for even more leverage. Now you can use your home as collateral for margin loans—obviously a danger again, particularly for amateur investors.

Authorities have also relaxed collateral requirements, no longer forcing investors to post additional collateral within two days if it falls below 1.3 times the amount of borrowed money, according to Bloomberg.

Brokerages may also now give six-month extensions to margin contracts, instead of calling the loans and liquidating the positions right away. The moves buy leveraged investors a little more time to put more on the line.

Those who can get out of their stock positions are exiting, and that frenzy spilled into global markets on Wednesday, July 8, where the Dow Jones Industrial Average fell to a five-month low amid a nearly four-hour suspension of trading due to an apparently unrelated technical failure. The S&P 500 dropped 1.7 percent, and the Nasdaq Composite fell 1.8 percent.

The Shanghai Composite Index fell 5.9 percent, despite around 40 percent of Chinese stocks being frozen from trading. The index is down 32.1 percent since mid June, about the amount it had gone up in a wild rally from April.