Over the past couple of weeks, as volatility in Chinese shares jumped, the market started to focus intently on the pledged-stock problem.
As you’re probably aware, China’s financial system is littered with land mines. The country’s labyrinthine shadow banking complex has long bedeviled those seeking to quantify hidden risks. The sheer complexity of it is “mind-boggling” (to quote a SocGen note from last year).
That’s part of what makes Beijing’s ongoing deleveraging effort so precarious. It’s impossible to know where all the credit extended through various shadow banking activities ended up. So when you squeeze those channels, strange things happen that in some cases were impossible to predict ahead of time. Throw in the duration mismatch issue and you end up with what amounts to a box of tangled Christmas lights.
“There exists a significant amount and a complex web of cross-holdings between banks and NBFIs as well as among NBFIs,” SocGen wrote in May of 2017, before lamenting that it’s “nearly impossible to have a clear idea who is responsible for what when things go wrong.”
Fortunately (at least from the perspective of “knowing the unknowns” – if you will) the pledged-stock problem that has everyone worried this month isn’t nearly as complex as something like, for instance, the infamous WMP puzzle.
Large shareholders pledge their holdings as collateral for loans. When the market takes a dive (as it has this year), brokers and banks (i.e., the lenders) demand more collateral. If the borrowers can’t or won’t put anything else up, the shares are liquidated into a falling market, exacerbating losses. Obviously, that has the potential to become self-feeding and the worry is that you end up with rolling margin calls and episodic bouts of forced selling.
Well, for what it’s worth, Goldman has endeavored to quantify this risk. On the bank’s estimates, some 5 trillion yuan worth of A-shares have been collateralized or, more simply, 11% of listed market cap. Goldman goes on to remind you that the 5 trillion figure is the notional amount, and given that lenders typically employ a 34-40% LTV in these transactions, outstanding stock pledged loans are roughly 2 trillion yuan.
Currently, Goldman says that considering YTD losses in mainland shares, around 1 trillion yuan in pledged-stock loans are at risk for liquidation (i.e., face margin calls). That, the bank says, “represents 49% of total loans outstanding, 2% of market cap, with the potential loss on SPLs accounting for 2% of aggregate brokers’ capital.”
That might not actually be all that catastrophic. But here again, it’s the self-feeding character of this that’s the problem.
“While the above estimates/risks look largely manageable, the self-reinforcing nature of SPLs makes this a dynamic risk factor”, Goldman writes, adding that “if the market falls another 10%/30% from here, Rmb1.2tn and Rmb1.7tn of the outstanding SPLs would be facing margin call/liquidation risks.”
The rest of this story kind of falls into place without even having to read any further into Goldman’s analysis. If you’re Beijing and you simply demand that brokers and banks don’t liquidate shares and/or instruct lenders to be flexible when it comes to margin calls, you’re just shifting the risk from the borrowers to the brokers/banks.
That’s fine as long as the brokers/banks have overcollateralized these deals enough to avoid taking a hit, but if they start taking on actual losses, well then you run into a situation where Beijing would have to start figuring out how to cut them a break from a regulatory perspective. And on and on and on.
The stop-gap “solution” is of course for state-backed entities to simply prop up private companies that are laboring under the weight of souring pledged-stock loans. That’s fine in the short-run, but it raises a series of questions over the longer haul, not the least of which are these (from Goldman): “a) adverse selection risks for stocks that don’t qualify for State support; b) moral hazard for major shareholders and market participants; and; c) rising concerns regarding rising State influences in private sector.”
So that, in brief, is the pledged-stock problem in China.
One certainly imagines it will “resolve” itself in the same way all other problems in China’s financial system get “resolved” – it will be swept under the rug or papered over, and if that doesn’t work and rolling margin calls do end up catalyzing sharp selloffs, then Beijing will just arrest the brokers and bankers liquidating the shares.