Shanghai traders now have more than 1 trillion yuan ($161 billion) of borrowed cash riding on the world’s highest-flying stock market.
The outstanding balance of margin debt on the Shanghai Stock Exchange surpassed the trillion-yuan mark for the first time on Wednesday, a nearly fourfold jump from just 12 months ago. The city’s benchmark index has surged 86 percent during that time, more than any of the world’s major stock gauges.

While the extra buying power that comes from leverage has fueled the Shanghai Composite Index’s rally, it’s also sending equity volatility to five-year highs and may accelerate losses if a market reversal forces traders to sell. Margin debt has increased even after regulators suspended three of the nation’s biggest brokers from adding new accounts in January and said securities firms shouldn’t lend to investors with less than 500,000 yuan [$81k].

“It’s like a two-edged sword,” said Wu Kan, a money manager at Dragon Life Insurance Co. in Shanghai, which oversees about $3.3 billion. “When the market starts a correction or falls, it will increase the magnitude of declines.”

Chinese investors have been piling into the stock market after the central bank cut interest rates twice since November and authorities from the China Securities Regulatory Commission to central bank Governor Zhou Xiaochuan endorsed the flow of funds into equities. Traders have opened 2.8 million new stock accounts in just the past two weeks, almost on par with Chicago’s entire population.

The outstanding balance of the margin debt on China’s smaller exchange in Shenzhen was 502.5 billion yuan on April 1. That puts the combined figure for China’s two main bourses at the equivalent of about $242 billion. In the U.S., which has a stock market almost four times the size of China’s, margin debt on the New York Stock Exchange was about $465 billion at the end of February.

David Fuller's view

This is obviously a concern, and here are 10-year weekly charts for the two mainland China indices: Shanghai A-Shares (p/e 18.70 & yield 1.72%) and the considerably smaller Shenzhen Composite Index (p/e 47.95 & yield 0.51%). 

For perspective, the US S&P 500 (p/e 18.24 & yield 2.00%) is on very similar valuations to the Shanghai A-Shares above.  However, the S&P Smallcap 600 Index (SML) (p/e 29.30 & yield 1.50%) is considerably less expensive than the Shenzhen Index above. 

The big question is what will China’s very hands-on monetary officials do about this surge over the last year?

The first point is that they have created the conditions for these moves and China’s command leadership has benefitted from them in terms of good will.  However, they will not want to undermine that by creating a large bubble.  This is certainly not the case for the Shanghai A-Share Index, at least not yet, but they may wish to let some air out of smaller Shenzhen Composite Index over the medium term.  I assume that they will take some action, probably this year.  They have various options, including raising margin requirements (the most sensible); jawboning the Shenzhen market lower (could appear heavy-handed), or reducing the monetary stimulus (presumably required for GDP growth). 

All of us who have investments in the China region should watch the Shanghai and Shenzhen Indices very carefully, because clear downward dynamics would indicate at least penultimate peaks of some duration.  However, unless you are a mainland China citizen and resident, your investments will almost certainly be primarily if not entirely in Hong Kong. 

This is certainly true of my personal and main long-term China play in the JPMorgan Chinese Investment Trust (JMC LN) (discount to NAV -8.71%), my second largest position, which is temporarily overextended but could hardly be described as a bubble.  The same can be said for the Atlantis China Healthcare Fund which I sold late last year to consolidate my position in the more diversified JMC.  These funds are invested largely, if not entirely, through Hong Kong which remains one of the best financial centres in the world.  I have frequently shown the Hong Kong HSI (p/e 10.64 & yield 3.57% and the Hong Kong HSCEI (p/e 9.02 & yield 3.40%) Indices.  I also have spread-bet longs in HSCEI, looking for a test of at least 14000.