The recent China stock market plunge demonstrates the power of leverage and signals the era of leverage trading in the China A share stock market. For that, it’s worth our remembering.
1. Shocking Facts
From June 12 to early July, the China A share market dropped 30%: the Shanghai Composite Index dropped from 5,166 to 3,623, and the ChiNext index, the Chinese equivalent of NASDAQ, suffered even more -- plummeted from 3982 to 2352, a 41 percent drop. The swift and violent decline ate up three quarters of the previous market rally since 2014. Why was it so fast and dramatic?
2. Government-Initiated and Fund-Driven Bubble
To understand the crash, we shall figure out how the bubble was built up first. The rally since mid-2014 was a government initiated and then leverage funding driven bubble. With prolonged economic weakness, vague economic reform, and increasingly serious public sector debts problem, the government turned to a relative easing monetary policy in order to relieve debt burden and spur the economy. What’s more, it demanded a “slow bull market” which would continuously attract investors to buy-in M&As and additional stock offerings of the state-owned corporations. It wouldn't take a hard effort to see the government’s will: regulatory officials frequently proposed the concept of “slow bull market”; People’s Daily, the mouthpiece of the Communist Party, strongly advertised the M&A deals of state-owned corporations and published articles specifically about the stock market, just like an ordinary financial media, which was really rare in the history of the newspaper. On April 22, it published an article saying that “4,000 points is just the beginning of the bull market”. What came along with the propaganda was a combination of monetary policy easing, state-owned corporation restructuring and investment expanding.
Surrounding by these signals and stimulations, the market was filled with optimism and investors believed the long lasting bear market finally passed away. Numerous themes and concepts emerged endlessly, such as “Internet+” and “M&A”. However, a significant seed that drove the market (and later crashed it) was planted in the meantime: the leverage.
There were two types of leverage: margin trading and underground financing. The former was well regulated, as the security companies were required to report the margin trading balance on a daily basis, while the latter was essentially private lending and shadow banking: people took advantage of regulation loopholes via various channels, such as trusts and P2P lending platforms, to borrow money from the banking system and invest in the stock market, which wasn’t legitimate otherwise. The leverage ratio of margin trading was 1:1, whereas that of underground financing could be anywhere from 1:5 to 1:10. In some extreme cases, 1:20. What’s more intimidating was that no one knew how much funds had been poured to the stock market through that channel.
When the market started going up, the plot mirrored any historical asset-bubbling story, like the tulip mania or the housing bubble. As long as price continues rising, no one would be hurt. And the fact that each player (lender, borrower, investor and public company) making profits reinforced this fact itself. That is, lender would become more willing to lend and borrower would become more willing to borrow. It was a self-reinforcing loop.
An electronic trading platform was also worth mentioning here: the HOMS (Hundsun Order Management System), as it played a vital role in the rise and fall of the market. The HOMS itself is merely an electronic trading software which features a full range of trading and portfolio management functions. It was popular among the security companies and the underground banks, for its easy-to-use fund distribution feature which was originally designed to help traders better monitor multiple accounts, but here it served as a perfect tool for the underground banks to monitor their clients’ (the borrowers’) positions, trading history, P&L reporting, and even mandatory liquidation if a client failed to meet margin requirement. With that, everything looked “safe and sound”.
3. Trigger: CSRC investigated the HOMS System in June
On June 12, the China Securities Regulatory Commission (CSRC) published a policy that banned the security companies from using the HOMS System, for it believed the underground banking system, connected via the HOMS system, had grown madly and driven the stock market speculation. As a result, investors who leveraged through the underground channel had to close their positions, especially those who with high leverage ratios. What’s more, the policy had a signal effect in that it showed a turnaround of the authorities’ attitude, which was a fundamental force underlying the rally.
Other than that, it was a tricky (or bad) timing to choke the underground banks, as June is usually the “money-starving” moment of the China financial eco-system. Every year, commercial banks have to handle two routine, yet very important, examinations from the central bank and the China Banking Regulatory Commission (CBRC) in June and December respectively, in terms of reserve ratio, loan-to-deposit ratio, and capital adequacy etc. Now that the investigation put stress on underground banks who eventually had to borrow from commercial banks, while at the same time the commercial banks themselves were tightening up credit to cope with regulatory examination. What was the result? a 135-bp jump in one-month SHIBOR (Shanghai Interbank Offered Rate) rate, a 95-bp increase in the weekly rate and a 33-bp increase in the overnight rate.
4. Leverage Spiral Mechanism
By that time, there was a balance about 3 trillion CNY sitting on leverage, compared to an average daily trading volume of 1 trillion. Soon after the initial adjustment, the high leverage ratio, say 1:10, investors were the first to be affected. If they couldn’t manage to meet the margin calls, they had to sell their holdings or their lenders would sell mandatorily. In either case, the selling behavior put an extra down force on the stock price and consequently drove the price even lower. It didn’t take long to reach the liquidation line of the 1:9 leverage ratio investors, and again, bring about another round of selling and liquidation, so on and so forth. Just like the formation of the bubble, its burst is also a self-reinforcing (and faster) loop.
It would be naive if we assume the investors who didn’t use much leverage were immune to the crash. In China, mutual funds were (I have to point out, relatively) better regulated and were not allowed to utilize high leverage in investment. However, with ranking pressure and career risk, many mutual fund managers overweighted small-cap growth stocks. Some even had significant holdings on thematic and M&A targets. To be fair, these investment decisions weren’t necessarily mistakes, as long as the managers could justify themselves. What’s unfortunate was that many of these stocks were exactly the holdings of the high-leverage investors at that time. When the price plunged, mutual fund investors became worried about their funds’ performance and decided to redeem their shares. The redemption activities soon dried up funds’ ordinary cash reserve and fund managers had no choice but to sell stocks. Once again, it was a vicious cycle: the more they sold, the more the price dropped. The more the price dropped, the more their investors were anxious, and the more redemptions. Let’s call it “mutual fund run”.
To sum up, this was the first time that the China stock market learned the sweet and bitter of leverage.
5. Intrinsic Reason: Over-valuation and Irrationality
In retrospect, what happened was no different than any other asset bubble in history. Over-value is the ultimate reason behind the scene and leverage just amplifies and expedites the correction. In mid-June, the Shanghai Composite’s P/E ratio was about 80, and that of the ChiNext Index was 151. What’s more interesting and surprising was the market already had a consensus at that time: yes, we know the fundamental is unsatisfactory and market is overvalued, and we admit it is mostly fund-driven, but you would be a fool if you miss this once-in-a-lifetime bull market. Fund-driven means the funds that entered earlier can only be profitable if there are more funds entering later. In other words, the investors who entered earlier can only be profitable if there are more investors entering later -- sounds like a word beginning with "P". Even with such a consensus, investors were buried by their greed.
6. Rescue Measures and Impacts
The government implemented several rescue measures during the market panic: lowered transaction fees, lowered reserve rate and interest rate, and suspended IPO, etc. All these measures, however, appeared in vain, because they were not the solutions to short-term liquidity squeeze. Both the the borrowers (margin investors) and the lenders (security companies and underground banks) were eager for liquidity, immediately. Three weeks after the initial sell-off, the crashing market finally saw its savior: the China Securities Finance Corporation (CSFC), which was set up by the government in 2011 and supported margin trading and shorting since then. The CSFC promised to bail out security companies and later directly participated in the market. With that, the panic gradually calmed down.
There were critics on the fact that the CSFC bought too many low-quality companies at irrationally high prices (even after the crash), which spoiled the risk takers and created moral hazard in future crisis. Also, the CSFC’s liquidity was injected from the central bank and commercial banks. It might increase long-term systemic risk, though it curbed short-term liquidity crisis. We may see its impacts on monetary policy and foreign exchange later on.
