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China's stock market may be about to receive another debt-fueled boost

Getty Images.

With China’s property market starting to heat up, the nation’s stock market has received little to no attention since the early parts of the year.

However, that doesn’t mean that nothing has been happening in the once high-flying market. Far from it. Stocks have been rallying hard, boosted by suspected state-backed buying from the so-called “National Team” during the National People’s Conference and bargain hunting in the wake of a 50% plunge in the benchmark Shanghai Composite index in the eight months to late February this year.

From the low of February 29 to last Friday, the composite has added 12%. Small cap indices such as the tech-heavy ChiNext — akin to the Nasdaq in the United States — have rallied even more, jumping over 18% since the start of March. Last week, the ChiNext rallied 12.5% alone, its largest one-week percentage rally on record.

Aside from suspected state-backed buying and bargain hunting, another factor may be adding to the bullish momentum: the return of margin financing.

Yes, the practice of buying stocks using borrowed money is making a comeback, spurred on by a reduction in interest rates and loosening of rules governing its use.

According to a report from Bloomberg, the China Securities Finance Corporation (CSFC), a state-backed agency that provides funding to brokerages for margin trading, will restart offering loans to securities firms for periods ranging from 7 days to 182 days.

The announcement, posted on the the CSFC’s website on Friday last week, also stated that it will cut interest rates on margin financing to as low a 3%.

The question many are now asking is whether investors will embrace margin financing yet again given the leverage-fueled bust that wiped trillions of dollars off the value of listed Chinese stocks last year.

“The loosening could reignite interest in the equity market, particularly as the regulators’ actions last year — to rein back private sector broker leverage — helped trigger the correction in equity prices,” Koon Chow, senior macro and currency strategist at Union Bancaire Privee in London told Bloomberg. “It does look like they want a second chance at growing the equity market. We shall all be watching very closely whether leveraged buying of the equity market balloons again.”

Between late 2014 through to mid-June last year, Chinese stocks soared on the back of a wave of margin-fueled buying from investors. At one point the benchmark Shanghai Composite index doubled in the space of less than a year before crashing 50% over the next six months.

Speculative forces, a dislocation from fundamentals and the use of borrowed funds acted in tandem to exacerbate the decline, ensuring many investors lost even more than their initial margin deposit.

Though the use of margin finance is commonplace in other major stock markets around the world, it has been particularly potent in China with the fluctuations in leverage closely mirroring movements in underlying indices.

According to Bloomberg, speculation that some commercial banks had resumed non-brokerage margin lending — something that was banned in mid-2015 — was partially responsible for the enormous gains seen in Chinese small cap stocks last week.

With valuations still extremely high, even compared to other emerging market peers, it’s little wonder that some investors fear that the decision will merely herald the return of speculative-driven, momentum-based buying that was a hallmark of Chinese stocks during the first half of 2015.

“The potential risks could be the brokerage firms misusing the leverage,” Wayne Lin, a New York-based money manager at QS Investors told Bloomberg. “If they use it for market making then it’s good. If they use it for speculation then it’s bad.”

Given the recent price action in Chinese stocks, it appears that it’s already fueling the latter.

You can read more from Bloomberg here.

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