Leverage overhang leaves mainland China stocks exposed to fresh falls

The mainland’s US$3.9 trillion stock market unwind could be barely halfway through, with a key price-to-earnings ratio still running at roughly twice the level analysts say is fair value and some US$600 billion worth of margin debt and collateral pledges left to clear.

Opaque off-balance-sheet lending has left money managers and financial analysts groping for reliable figures on which to base estimates of further downside risk, even as mainland stock markets enter a second week of relative calm after their biggest battering in at least seven years.

“The question is what do you do now?” Francis Cheung, head of China-Hong Kong strategy at broker CLSA, told the South China Morning Post. “The market is not cheap and the problem is that as the margin finance gets cleaned out, you’re taking out a lot of things that support the market at current levels.”

Cheung calculates that mainland shares are trading at a price-to-earnings ratio of 33 times when banks are excluded.

Beijing ordered state-backed lenders to help fund a clean-up of the financial mess left by a three-week rout that started in mid-June. Stripping out that policy support mechanism, and its implicit drag on overall earnings for constituents of the Shanghai Composite Index, leaves the market trading at roughly twice the fair value level that strategists at firms such as AXA Investment Managers believe is viable.

“Leverage is still high, and further deleveraging, which is necessary, will create selling pressure,” AXA analysts Aidan Yao and Franz Wenzel wrote in a recent note to clients. “Valuations, outside the large blue chips, are still expensive, resulting in a natural tendency for correction. We see a further 10 per cent to 20 per cent market decline from here, with a [maximum] peak-to-trough correction of 40 per cent.”

The policy dilemma for Beijing is that having ordered a clean-up of the market to deliver a slow, sustainable bull run that fosters long-term stability in the financial system, more downside risk is likely to be stacking up in the short term.

Official margin finance – the money borrowed to buy stocks which has been largely blamed for the market turmoil – has fallen by around 40 per cent from its June 18 peak of some 2.3 trillion yuan, though that still leaves it running at around 8 per cent of stock market capitalisation.

“We think a sustainable ratio would be on the order of 3 per cent to 5 per cent,” analysts at Morgan Stanley wrote in a recent report.

That implies the potential withdrawal of some 720 billion yuan of stock market leverage from current levels.

The bigger problem is the level of unofficial margin finance, which analysts estimate to have been worth up to 2 trillion yuan at the height of market euphoria. There could still be 1 trillion of that left to be repaid.

But it is the amount of money loaned to company executives who have pledged shares in the companies they control as collateral for credit that worries analysts at HSBC.

They calculate that stock pledge loans have leapt to 1.5 trillion yuan so far this year – more than was borrowed through the channel in the whole of last year – and that the total outstanding market value of such transactions is now around 2.5 trillion yuan.

While much of this is concentrated in the hands of domestic brokerages, for which Beijing has ordered liquidity support, the market overhang remains substantial.

“Unless the economy does much better than expected, unless earnings growth does much better than expected – and I don’t see that on the cards – then there’s just downward pressure on the market,” CLSA’s Cheung said.

The only potential cushion he sees breaking the broad price falls that many of his fellow analysts anticipate is the inclusion of US-listed shares of 17 mainland firms in the benchmark MSCI China Index in November.

That move will dilute the dominance of slow-growth, state-owned enterprises in the index, adding in the internet and consumer-oriented firms that are driving profit growth and the “new economy” of China and thus lifting the earnings multiple of the index.

“You can say that this is a technical change, but guess what, when the world looks and sees an index that shows China at 12 per cent earnings growth trading at only 10 times PE, then maybe that’s the time to start putting some more money in,” Cheung said.

Until then, he says the only sensible strategy is to clear the decks, with the government having effectively set a price floor for the Shanghai Composite Index at 3,400 and a top at 4,500.

“For people who are more leveraged than they thought they should be, perhaps it is time for them to be thinking they’ll take whatever profits they have left and leave the market,” Cheung said. “The government is giving them an opportunity to do that. It’s time to clean house.”