By Samuel Shen and Engen Tham
SHANGHAI (Reuters) - A sharp drop in mainly small-cap Chinese stock prices has exposed a new and potentially destabilizing pocket of leverage in the world's second-largest economy.
The value of shares that shareholders have pledged as collateral to borrow money, mainly from brokerages, has quadrupled over two years to more than 6 trillion yuan ($898 billion), or a tenth of the total value of China's stock market, according to estimates from Bank of America Merrill Lynch (NYSE:BAC) and BOCOM International.
For small-caps and start-ups, the proportion of pledged shares is higher, making up almost a fifth of companies' combined market value - or nearly $400 billion as of end-2016. Across the rest of China's stock markets, stock-collateralized loans account for 7.3 percent of total share value.
These loans were taken out when share prices were strong, with shareholders borrowing against their shares and using the proceeds for everything from buying shares to repaying loans and investing in other companies, and sometimes luxury properties, analysts say.
But investor interest in small-caps has waned this year, with the ChiNext start-up market down more than 8 percent and Shenzhen's predominantly small-cap SME board down more than 5 percent. In contrast, the blue-chip CSI300 index is up nearly 8 percent.
That has left a growing number of borrowers scrambling to avoid forced liquidation, where brokers make them sell the shares they have used as collateral.
Dongguan Kingsun Optoelectronic, which makes LED lighting products, and textile producer Dohia Group, for example, were among more than 100 companies flagging problems with stock-collateralised loans. They suspended trading in their shares in April and June, respectively, citing margin calls being triggered after their share prices slumped.
If markets continue to slide, there could be a surge in margin calls on these loans, potentially triggering a vicious cycle of share selling, increasing the risk of broader financial instability, analysts warn.
"If stock prices fall, but shareholders don't have enough capital to replenish their collateral, the pledged shares would face forced selling," said Meng Shen, director of Chanson & Co, a Beijing-based boutique investment bank.
"That would develop into a negative spiral; as the more you sell, the lower the stock price, which would then trigger more forced selling."
China has a broader issue with collateral that could endanger the health of its financial system – fraudulent or "ghost" collateral, where pledged products either don't exist or are already sold or pledged to multiple lenders.
BofA Merrill Lynch strategist David Cui warned that a potential "vicious selling circle" could lead to a replay of China's mid-2015 market crash.
"As the 2015 experience shows, with high leverage, a vicious selling circle can quickly develop," he said, noting a "moderate" risk of broad-based financial instability.
The stock market crash nearly two years ago, when the Shanghai stock index lost 40 percent of its value in three months, was fueled largely by an unwinding of margin financing for stock purchases.
The China Securities Regulatory Commission, which oversees the country's stock markets, and the China Banking Regulatory Commission, did not respond to emailed questions about the share collateral issue.
MARGIN CALLS
Last month, as the ChiNext fell to near 2-1/2-year lows, more than 140 mostly smaller listed companies announced their shareholders had pledged additional shares to shore up the value of their loan collateral. That compares with 60 such cases in April, and fewer than 40 in January-March.
Dongguan Kingsun Optoelectronic said its shares were suspended after controlling shareholders Li Xuliang and his sister Li Shuxian faced margin calls. They had already resolved the issue - raising fresh money from investors to deposit with lenders - so didn't need to sell the stock. Still, share trading remains suspended as the company plans to divest some assets, the official said.
Stock filings show that Shenzhen-listed Dohia's founders Chen Jun and Huang Yani have pledged a total of 50 million shares, or 43 percent of the company's total shareholding. Dohia's stock price has more than halved over the past month.
An investor relations officer for the company said measures had been taken to reduce collateral risks, including "pledging deposits or more collateral". He did not elaborate.
The major shareholders at both Dohia and Dongguan Kingsun could not be reached for a comment.
BUSINESS FOR BROKERS
Xia Zhengzhou, an analyst at Kaiyuan Securities, said the ballooning in stock-collateralised loans had been driven by high share valuations and by brokerages looking to expand their revenue streams.
Brokerages ranking high in this area include Haitong Securities, which has said it had stock-collateralised loans of 140.6 billion yuan at the end of last year, and is looking to do more. Third-ranked Guotai Junan, with outstanding stock-collateralised loans of 69.3 billion yuan at end-2016, said in its annual report that it remains "cautious and active", while maintaining rapid growth.
The fastest growing include Founder Securities and Sealand Securities. Both say they take measures to control credit risks - from screening and educating investors to monitoring markets in real-time and forced liquidation where necessary.
"This year, we have strengthened risk management and compliance (in the collateral credit business)," an investor relations official at Sealand Securities said.
"Falling stock prices don’t necessarily lead to defaults."
