THE SEA OF LEVERAGE IN CHINESE MARKETS / THE WALL STREET JOURNAL

The Sea of Leverage in Chinese Markets

Large chunks of China’s stock markets have been pledged as collateral for loans

By Jacky Wong



COLLATERAL DAMAGE
Leveraged positions in China A share markets, as a percentage of market capitalization

Source: Bank of America Merrill Lynch

Passive investors are about to get more involved in Chinese stocks thanks to MSCI’s decision to include several of them in its key indexes. They will find themselves exposed to a market swimming in leverage.

About $1 trillion worth of stocks listed in Shanghai or Shenzhen—China’s two main markets—are being pledged as collateral for loans, according to data from the China Securities Depository and Clearing Corp., or ChinaClear. That’s equivalent to about 12% of the market.

Plenty of Chinese stocks are also used as collateral in margin financing, whereby investors borrow to plow more money into stocks. In all, some 23% of all market positions were leveraged in some way by the end of last year in China, according to Bank of America Merrill Lynch. 
    An investor monitors stock prices at a brokerage house in Beijing in 2016. Photo: Mark Schiefelbein/Associated Press 



The pledging of shares as loan collateral is particularly prevalent among smaller private companies. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds. 
It isn’t always clear where the money they raise ends up. Former technology star Jia Yueting pledged his majority shareholding in Shenzhen-listed Leshi Internet Information & Technology to get funds to fuel his ambitions for the company from electric cars to film studios. The company still suffered a cash crunch last year, after which it was suspended from trading for nine months.



The risk for other investors when big shareholders take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors likely made the crash worse.


MSCI has limited its coming index inclusion of domestic Chinese shares to only big cap stocks, but that doesn’t mean it is free of problems. Some new entrants such as Kangmei Pharmaceutical , China Grand Automotive Services or Giant Network Group have about half or even more of their shares pledged as collateral for loans, based on data from ChinaClear.

Investors thinking of following MSCI’s lead and plunging into Chinese stocks should be aware of such hidden risks.