One of the few things that might be said for the Greek crisis is at least it helps take the mind off the story currently unfolding in the Far East. Still, while many investors have been worrying about how far China’s domestic markets have fallen since last month’s high, here in the Schroders value investing team we are more alarmed by the fact they are still so far above where they were a year ago. 
As we will see in a moment, there is the potential for matters to deteriorate further – and very quickly. To pin the numbers down to one point in time, however, as of 8 July, China’s main Shanghai index had fallen 32 per cent from its 12 June peak while the Shenzhen index was off 40 per cent.
Phenomenal falls, of course – and yet the Shanghai was still up 74 per cent from where it was in mid-2014, with the Shenzhen still up 84 per cent. There is, in short, plenty of scope for a lot more pain.
To help illustrate our point, let’s focus in on just one aspect of an extremely complicated situation – margin debt. This is money investors borrow from their stockbroker to buy shares and, as you might expect, the more bullish they feel, the more they are inclined to borrow. As such, margin debt levels are often seen as a way of gauging market sentiment.
As we noted recently: “Keen students of behavioural finance may not be too surprised to learn that, over time, margin debt levels have tended to be at their highest just before markets crash while, just before markets take off, investors tend to have net cash in their trading accounts.”
Bearing all that in mind, take a look at the chart below, which shows the amount of margin debt outstanding in China.
Source: Bloomberg 9 July 2015; Schroders
As with many charts based on statistics emanating from China, this one carries the inevitable caveat that it may not be 100 per cent reliable. Even so, the data is consistent and has been compiled over a period of time and thus, while the actual level of margin debt is probably a good deal higher, you can at least see which way and how fast things were going – and are now.
The regulations governing what percentage of margin debt investors are allowed to borrow differ from country to country but in China there effectively have not been any. Until recently that is, when the Chinese authorities tried to tighten up the rules – a move that a number of commentators believe may in fact have provoked the current crash.
The thing is, if the margin debt rules (or lack thereof) have enabled you to borrow 100 per cent of the money you needed to buy a stock and the market starts to fall, it becomes very difficult to pay off that debt.
Say, for example, you manage to pay off 30 per cent of your debt but the stock you borrowed against falls 30 per cent as well, then you are still margined 100 per cent.
In other words, and as the chart below illustrates, your outstanding debt as a percentage of the value of your stocks has not moved. Looked at more widely, that means the pressure on people to sell today is as big as it was at any point since mid-June, which suggests we are still potentially right in the middle of this downward market spiral.
A-share margin financing balance vs fee float market cap
Source: CEIC, Morgan Stanley Research, as of 3 July 2015; Schroders
Only compounding the problem is the way investors who have borrowed to buy shares can go about releasing capital to pay off their margin debt. They might, for example, raid their savings but the most obvious place to find the cash to pay their margin is to sell the stocks they own. Of course, that only magnifies the downward spiral – and, we are afraid to say, it gets even worse.
According to Zero Hedge, as of 7 July, trading in 54 per cent of all Chinese stocks – that is, $2.6trn (£1.7trn) worth or 40 per cent of the entire value of the market – has been suspended. So not only are people having to sell off stocks to fund their debt requirements and keep their collateral levels on an even keel, they are no longer able to touch half of what is in their portfolio.
If margin-debt investors look to sell off those businesses they can still trade, it will hurt the market, and if they look to find the money elsewhere, it will hurt the real economy. Either way, it is bad news for China and, as you might expect, the powers that be have been doing there best to help prop up the markets – which of course introduces a whole new set of concerns.
To pick out just a handful of measures, companies are now actively being urged to buy back their own shares; the maximum amount Chinese insurers may own in single blue-chip companies has suddenly been raised from 5 per cent to 10 per cent; and brokerage firms have been forced to contribute some $19bn to a so-called ‘market stabilisation fund’.
That last point highlights the fragility and interconnectedness of this whole business because it is not so long ago that China’s brokerage firms were taking advantage of the bull market to raise money to … that’s right, lend to investors on margin. According to the Financial Times, shares in the six brokerage houses listed in Hong Kong have each halved in value since the 12 June market peak.
Given our naturally contrarian nature, you might think China would be starting to pique our interest. Not a chance. We would not presume to guess how this is all going to end but, as we have suggested, there are some very powerful forces at work here. As ever, we will be guided by valuations and, regardless of the events of the last month, these continue to look stretched.
Jamie Lowry is a member of Schroders’ value investing team and writes on The Value Perspective. The views above are his own and should not be taken as investment advice.
