Chinese stocks continue to surge on the back of borrowed money

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Chinese stocks continued their epic bull market run on Friday with gains in excess of 2% reported on both the Shanghai Composite and Shenzhen 300 indices.

The amazing run, something that has seen both post 12-month returns of 130% and 129% respectively, has come against a backdrop of weakening economic conditions in the Chinese economy.

While monetary policy easing from China’s central bank, the PBOC, has partially contributed to the substantial rally, it does not explain the whole story.

One major factor has been the increased use of margin debt to finance share purchases — essentially borrowing to increase leverage and, if markets continue to rally, greater potential returns.

The role of margin debt contributing to the substantial rally isn’t new — even the RBA covered it in its most recent quarterly statement on monetary policy — but it appears that its role may only continue to grow despite the lofty heights being hit almost-daily in Chinese equities.

According to the FT, using analysis provided by Macquarie, Chinese brokers have raised $US14 billion in new capital so far in 2015 — trebling the amount raised over the past three years combined — with more than half of that amount being allocated to new margin loan facilities for investors looking to increase their exposure to the equity market rally.

Macquarie note that the amount of debt used to finance A-share purchases — those domiciled in mainland China — now stand at $US307 billion, up 84% since the beginning of the year and some four-times greater than the levels of a year ago.

It’s been an amazing debt-fueled splurge, and one not without its risks.

Just as margin debt can amplify gains through increased leverage should stocks continue to rally, they can also magnify losses should the market rally begin to falter.

Having run so hard so fast, should Chinese equities markets begin to slide, it could see losses of substantial magnitude.

Like a game of dominos, should those investors who have taken out margin loans be forced to liquidate their positions it will place further pressure on the index and, as a consequence, other investors with leveraged positions.

The results can be savage if the weakness persists beyond the short-term.

Given Chinese markets have barely seen any form of weakness in the past nine months, it’s hard to gauge how substantial the falls will be when the markets begin to correct.

However, with more and more margin financing expected to flood the markets in the coming months, one suspects that when the correction does eventually arrive the combination of leverage and lower levels of investor sophistication will ensure a swift, savage and almost-certainly painful drop.

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