21 July 2018
The A-share bull run has returned about 60 percent since June 2014 compared with a total return of 260 percent in the 2005-07 bull market. Photo Bloomberg
The A-share bull run has returned about 60 percent since June 2014 compared with a total return of 260 percent in the 2005-07 bull market. Photo Bloomberg

Will stricter margin trading rules end A-share rally?

Conventional wisdom has it that margin trading has been fueling most of China’s A share rally since 2014.

So when the China Banking Regulatory Commission (CBRC) announced stricter rules on margin financing and reprimanded some Chinese brokers for breaking lending rules, A shares dropped by almost 8 percent on the day (Jan. 19) and has since had a weak bias.

Many players fret that the regulator might have put the final nail in the coffin of the A share rally. Or has it?

It is true that margin financing in the A-share market has risen sharply to about 3.5 percent of total market capitalisation from 2 percent in early 2014.

In my view, the authorities are not aiming to reverse or suppress margin trading.

Rather, they want to stabilize it and regulate it more properly so that it will not become a driving force for building a stock market bubble.

In the CBRC’s move, only three major brokers were banned from margin trading for three months; another nine were given warnings.

If it had wanted to “kill” margin trading, or the A share bull run as some players have speculated, it would likely have taken more drastic actions.

For example, it could have banned all brokers from margin lending to finance stock punting for a much longer period, or sharply raised the required margin coverage ratio from 130 percent of the margin-financing account balance.

Margin trading, when managed properly, helps provide market liquidity that, in turn, facilitates efficient pricing in the equity market. So it is not a problem by itself.

Chinese regulators just want to better regulate the risks associated with the emergence of margin-financed investment activity, especially the incentive to break the rules and to abuse bank credit.

Experience shows that regulatory changes are not necessarily harmful; rather, they are a temporary disruption to a bull market trend.

During the 2005-2007 A-share bull run, the Ministry of Finance increased stamp duty from 10 basis points to 30 basis points of the settlement amount in May 2007.

Shanghai A shares fell by almost 14 percent over the following five trading days and then resumed their rally.

The market rose by another 60 percent after the correction, reaching a peak on Oct. 16, 2007.

What’s more, before the hike in the stamp duty, the central bank had four rounds of bank reserve requirement ratio increases and one interest rate hike.

All these moves failed to deter the A-share bull market from advancing. What cracked the market was the exogenous shock from the US subprime crisis in late 2007.

The current A-share bull run has returned about 60 percent since June 2014 compared with a total return of 260 percent in the 2005-07 bull market.

The question is whether the fundamentals are still there to propel the market higher?

A shares are still reasonably priced. Shanghai A shares are trading at an average of 15 times price-earnings (PE) ratio which is still lower than its long-term average of 21 times.

The 2005-07 rally started when the Shanghai A market was trading at almost 20 times PE and the stamp duty hike was introduced when the market was trading at more than 40 times PE.

However, China’s “new economy” stocks, mostly traded in Shenzhen, those in the IT, telecom, health care and consumer sectors, are trading at about 26 times PE on average.

This is still cheaper than their counterparts in India and Thailand, although they are slightly dearer than similar counters in Hong Kong and Singapore.

The favorable structural and policy dynamics that are unfolding in the Chinese economy and rising buying momentum due to increasing participation by the local investors are the key factors supporting A shares in the coming year.

Returns on other investment alternatives, including property, bonds and wealth management products, have fallen sharply since 2014, driving investors back to the stock market, disregarding whether there is margin financing or not.

This is seen in the robust momentum in new stock account opening by onshore retail investors and in trading volume expansion.

These two indicators have high positive correlations with the A-share index’s performance, suggesting that positive momentum would support the A-share rally for a while.

Fundamentally, lower oil prices and moderate economic growth will translate into a benign inflationary environment which is conducive to further policy easing by Beijing.

We can expect more cuts in interest rates and the bank reserve requirement ratio in the coming months, together with more targeted easing measures.

All this conjures up to a positive liquidity environment for the A-share market. This is in sharp contrast to the tightening monetary policy backdrop that occurred during the latter part of the 2005-07 A-share bull market.

But the A-share market cannot be risk-free.

An unexpected sharp deceleration in China’s GDP growth, which could abruptly cut stock valuation, and an unanticipated shock to investor sentiment stemming from Beijing’s anti-corruption campaign and policy overkill from regulating market activities would be potential risks that need to be monitored closely.

Opinions expressed here are the author’s and do not necessarily reflect those of BNPP IP

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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