CHART: A huge unwinding of Chinese margin debt is driving the sell-off, and it's not done yet

If there is one thing we know in markets it is that when purchases are made on margin the buyer is vulnerable to a reversal of price and the associated margin call which will force them to put up more cash, or sell. When it’s one person, a couple, a few, a score, or even one hundred people it hardly matters.

But when a good percentage of the entire market is being financed on margin then the very market prices that the margin buying is driving higher become vulnerable to a rush to the exits and forced selling from leveraged traders if prices fall, let alone collapse.

That’s essentially what is happening on the Shanghai stock market according to Morgan Stanley in a note from the China Equity Strategy Team. They believe the selling is a healthy correction for the market and would “like to see further margin unwind, valuation normalization and/or corporate earnings improvement before we turn more constructive on China A shares.”

That is, Morgan Stanley want to see prices fall a little further before they want to buy stocks.

In the interim they said that deleveraging is ongoing in A-share market and that the margin financing to free float market cap ratio still high. That’s a measure of how much leverage is in the market.

They added:

We do note that the quantum of margin financing outstanding, one of our key concerns, has fallen by 22% from the peak at US$371bn on June 18 to US$289bn as of July 6. This reflects that the A-share market is going though a deleveraging process, which is encouraging, in our view. However the ratio to free float market capitalisation is still at 9% as market cap.

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