The benchmark Shanghai Composite index had its worst day yesterday since the market crash that ushered in the Great Recession. The Shanghai market has had an impressive run up in the last half year outdistancing the S&P 500. It turns out, however, that many traders with very little capital have been trading Chinese stocks on margin. The chickens came home to roost yesterday when securities regulators penalized three major brokers for allowing traders with insufficient capital to trade on margin. The result was an impressive drop of over more than 7 percent in Chinese stock market. CNBC covers the story.
Chinese stocks plunged Monday after the country’s securities regulator rapped three major brokerages for continuing to lend money for stock purchases in violation of rules. As punishment for extending so called “margin trading” contracts, the brokerages are forbidden to offer credit to new customers for three months.
At one point Monday, the Shanghai Composite Index was down 8.3 percent. It later trimmed that to a loss of 7.7 percent. Share prices of brokerages were hardest hit, with some falling by the daily loss limit of 10 percent. Despite the sharp fall, the Shanghai Composite Index is still up 55 percent in the past 12 months and up 33 percent for the past three months.
Investors and analysts see the penalties against the brokerages as foreshadowing more curbs on credit-financed trading by China’s government. Authorities want to stop the stock market’s boom over the past year from turning into a bubble that could damage the broader economy.
The Chinese market has benefited from a lot of new investors recently as speculators are pulling their money out of the collapsing real estate market. The risk that the government sees is another asset bubble ready to burst and it is taking steps to cool off the market.
Situation Currently Limited to China
According to The Guardian markets outside of China are little affected by enforced limits for trading Chinese stocks on margin and the resulting stock market fall in Shanghai.
Despite the slump on the Chinese stock market - driven by efforts to clamp down on the margin trading which has driven share sharply higher - European investors were in a positive mood ahead of the European Central Bank meeting on Thursday. There is some concern as the Greeks go to the polls next week, but for the moment the prospect of some form of quantitative easing from the ECB is pushing markets higher. Banks in particular were in demand, as the FTSEurofirst hit a seven year high.
The Eurozone has its own problems but one of them is not the lack of transparency that threatens investors in China. The other issue is that there are strict limits to how much foreigners can invest in Chinese markets. If you want to trade Chinese stocks it is a lot easier to buy or sell American Depository Receipts.
Ready for a Correction
The Shanghai market was probably ready for a correction and the penalties for brokerages having low asset traders trading Chinese stocks on margin may simply have been an excuse for many to take profits in and get out of an overheated market. The Wall Street Journal notes that response to the the trading crackdown was related to investor concerns that the market would fall.
Shanghai stocks plunged to their lowest level in more than six years Monday as investors worried that Beijing’s move to clamp down on margin trading could derail the benchmark index’s months-long winning streak.
In short it was a self-fulfilling prophecy. Traders were looking for a hint that the market would correct and apparently started to sell at the first news of the crackdown. Then traders will insufficient collateral to cover margin calls saw their accounts disappear and the downward rush was on.
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