China Threatened By "Vicious Circle Of Panic Selling" From Marketwide Margin Call

One of the more prominent risks facing the Chinese stock market, and potentially explaining why the Shanghai Composite simply can't catch a bid during the recent rout, is the risk of a wave of margin calls resulting in forced selling of stocks pledged as collateral for loans.

The pledging of shares as loan collateral - a practice that has gotten increasingly more popular over the years - has been especially prevalent among smaller companies.

The risk for other shareholders is that when major investors take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble, and are forced to liquidate stocks to repay the loan. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors was likely a key factor.

The marketwide numbers are staggering: about $1 trillion worth of stocks listed in China's two main markets, Shanghai or Shenzhen, are being pledged as collateral for loans, according to data from the China Securities Depository and ChinaClear. More ominously, this trends has exploded in the past three years, and according to Bank of America, some 23% of all market positions were leveraged in some way by the end of last year in China, double from the start of 2015.

Shares pledged as collateral for loans account for ~10% of total A-share market cap, with 123 companies over 50% pledged, amounting to a combined pledged market cap of RMB1.0 trn, or 2% of total A-share market cap.

Furthermore, so far in 2018, there have been ~50 A-shares that have suffered price declines over 60%, with an average pledge ratio of 28%, thus likely falling below margin closeout level.

Should the Composite market slide another 100 or so points, taking out the critical support at 2,655, then regulators may finally be forced to tap banks and brokers on the shoulder, and demand companies repay loans. The resulting stock mass liquidation could also be the trigger Trump needs to demand capitulation from Beijing as part of the escalating trade war. The big question is, if indeed this is the endgame, whether China will allow this to happen without retaliation, or if Beijing - having little to lose - will sell a few hundred billion Treasurys to punish US capital markets as its own stock market crashes and burns.

As far as I'm concerned, let the Red Chinese sell their treasuries.  The market for those is huge, and while the financial pain they can inflict is going to hurt, it lasts only for a while, and once over, their leverage is gone.