China's stock regulator is clutching at straws

Beijing’s measures in favour of margin trading will destabilise the market and scare away ordinary investors as volatility takes its toll

PUBLISHED : Friday, 31 August, 2012, 12:00am
UPDATED : Saturday, 01 September, 2012, 8:09am

Beijing's efforts to talk up the mainland's domestic stock market are sounding increasingly desperate.

This week the China Securities Regulatory Commission said it would relax restrictions on margin trading, allowing investors greater leeway to leverage up and buy stocks with borrowed money.

This is just the latest in a series of attempts by the regulator to boost prices. In recent months CSRC officials have repeatedly told investors that equities are a bargain, while pressing companies to buy back their own stock, even allowing managers to offset the cost by paying employees in shares.

Nothing has worked. The benchmark Shanghai Composite Index has slumped 20 per cent over the last year, closing yesterday at its weakest level since the depths of the financial crisis in February 2009 (see the first chart).

In response, the regulator has decided to ramp up margin trading. Until now, brokers have only been allowed to lend to clients from their own cash holdings. Under the new rules, however, brokerage houses will be able to borrow money from other financial institutions in order to fund loans to their customers.

You can imagine why someone thought this might be a good idea. According to the official China Securities Journal, the new margin facility will inject some 120 billion yuan (HK$146.8 billion) of fresh liquidity into the ailing market.

All that new money coming in should help to boost prices and improve sentiment, the CSRC obviously figured.

If that really was the regulators' reasoning, it displays a lamentable ignorance about how markets actually work. In reality, margin trading is likely to do far more harm than good.

Experience in developed markets shows that allowing trading on margin has little effect on long-term price levels, but that it can significantly exaggerate short-term volatility.

On the mainland, this effect is likely to be amplified. With little faith in the accuracy of company reports, domestic investors pay little attention to the sort of valuation measures popular in maturer markets.

Instead of searching for undervalued stocks to purchase and overvalued ones to sell, the majority of investors are trend-followers. The higher prices rise, the more shares they buy. The further the market falls, the more they sell. The result is that trend-followers have an unfortunate tendency to buy when prices are high, and sell when they are cheap. Allowing margin trading will only exacerbate that tendency.

If the market rises, speculative investors will leverage up and pile in, driving prices even higher. Should the market move against them, leveraged traders will then very rapidly find themselves facing margin calls, as their brokers demand they post more collateral against the money they have borrowed to fund their positions.

In response many will choose to close their positions by selling into the sinking market, which will simply magnify the extent of the fall.

As a result, margin trading is likely to achieve the exact opposite of what the regulator wants. Far from boosting prices and restoring confidence, it will destabilise the market and scare away ordinary investors. In allowing it, the CSRC is clutching at straws.

The past 10 years have hardly been kind to the US stock market. It has had to work off the excesses of the dotcom era.

Then there was another bubble, inflated largely by money borrowed against the rising values of investors' homes.

Inevitably the balloon burst, and growth in the real economy has been anaemic ever since.

In contrast, over the same period the Chinese economy has boomed, growing at an average rate of 10.6 per cent a year.

So ask people which stock market has performed better, the US or China, and most immediately say "China".

But as the second chart shows, the US market has actually done more than twice as well as China's. Over the last 10 years, the US S&P 500 index has climbed 54 per cent, while the Shanghai composite has managed gains of only 23 per cent.

That should give the CSRC some food for thought.