Chinese Learn About Margin Calls as Stocks Drop Most Since 2007

June 26, 2015 Updated: July 2, 2015

Many people thought China’s stock market would be a one-way street straight up to trader heaven with free money for everyone. One farmer recently said that it’s easier to make money from stocks than farm work.

However, the one-way street took a little detour the week of June 15–19 and continued to go in the wrong direction this past week, with the Shanghai Composite down 19 percent from the highs around June 16 and the Chinese Nasdaq (ChiNext) was down 27 percent.

Of course there are plenty of reasons why Chinese stocks should go down. First of all, they are massively overvalued after a 125 percent rally in the last 12 months. The forward price earnings ratio of 24, is higher than the historic average and higher than other developing countries.

And when even umbrella manufacturing companies are trading at 166 times earnings, you know something is out of whack.

Other technical reasons include some liquidity draining measures by the central bank, albeit on a small scale, and some negative reports by brokerages such as Morgan Stanley and Bank of America.

Because China uses the stock market as a policy instrument, the absence of positive reporting on it by Chinese media has also played a role.

“The tone from state media is particularly helpful to retail investors like me, as I have a job to do and am pretty busy,” Yao Lina, a 35-year old accountant in Shanghai told Bloomberg. “China’s stock market is really different from other countries. The government surely has some measures to control the movement.”

And it seems to want to cool down this movement because brokerages have recently reduced access to margin or debt financing where traders borrow money to buy stocks.

As of June 15, this margin debt totaled $358 billion, roughly 10 percent of China’s stock value not in the hand of long-term owners.

The good thing about margin debt is that it keeps stocks going up even if nobody has money left to buy them. It also helps to make multiple returns on the money the investor puts up himself.

The bad thing about margin debt is that as soon as stocks start declining, your own money (equity) is soon wiped out and the broker will give you a “margin call,” forcing you to sell everything so that he can get his money back.

This leads to lower prices, more losses, and more sales and it is a common phenomenon throughout global equity markets. In China, it’s just bigger than everywhere else.