China’s Stock Rally Rears Its Ugly Head

May 5, 2015 Last Updated: May 7, 2015

There are positives and negatives about debt fuelled stock market rallies. They make people happy because they go up in a straight line most of the time. The bad news is, when there is a down day, it’s a nasty one.

In China, the Shanghai Composite index is up 112 percent over the year, which pretty much fits the straight line criterion. It has benefited from central bank liquidity and lax margin lending requirements. So the Chinese public has flocked to invest in stocks, opening 3.25 million new brokerage accounts in one week of April alone. They have borrowed a record $290 billion to buy stocks.

“If you look at the new accounts opened and the Shanghai Composite, they pretty much go line in line,” says Peter Tchir of Brean Capital.

The problem is, if there is a down day, it’s going to be a nasty one, and often it only takes a little bit of bad news to necessitate it. On Tuesday, some banks have reportedly tightened margin requirements, according to Shanghai Securities News, and the Shanghai Composite promptly dived 4 percent.  Property was hardest hit, falling 8 percent after a three-month 52 percent winning streak until the end of April.

Chinese stocks have rallied more than 100 percent during the past year, and this is before official QE even started (Google Finance)
Chinese stocks have rallied more than 100 percent during the past year, and this is before official QE even started (Google Finance)

Another concern are the 25 IPOs coming to the market at the beginning of May. According to Bloomberg estimates, they are worth around $380 billion, which means this money won’t flow into existing stock issues, but rather into the new ones.

Swings in debt-driven markets are usually very volatile because of margin calls. If you borrow money to buy stocks and your stock goes down, at one point the equity you had in your account will be wiped out. The broker will then force you to sell your positions in order to repay the borrowed money.

This usually leads to a lot of forced selling, putting pressure on prices, which leads to another round of accounts being under water and a new round of selling. A vicious cycle.  

This is why China is trying to manage the rally as much as possible, despite having admitted in private it is using the rising stock market as a policy tool.