By: Our Correspondent

It is time for investors to get cautious about the China markets, which have gone stratospheric since the beginning of 2014, with an unsettling amount of the investment built on scary margin debt at a time when the Chinese economy is clearly struggling. 

After Chinese authorities connected the Shanghai market to the Hong Kong Exchange last autumn, allowing foreigners into China trading in serous volume, the Shanghai Composite bounced upward by 69 percent. The Shenzhen Composite has risen by 72 percent after both had been among the world’s worst performers for the previous three years.

The action has been in bursts.  In December,  the Shanghai market surged by 21 percent in 10 days before drifting sideways, then going on a tear since early March, rising by 7.5 percent in a week to March 20, their biggest weekly gains in  three months, built apparently on expectations that the government would do more monetary easing.  The People’s Bank of China has injected at least RMB 1.35 trillion into the economy and cutting interest rates.

But underlying this is margin debt balance. Most famously, buying stocks on margin – borrowing from a brokerage through a margin account and betting stocks will climb rapidly to leverage investment  – left huge sections of the US economy in ruins when Black Friday struck the market in 1929.  The Chinese regulators reportedly have warned stockbrokers to cut back margin lending, to little effect.

That is because the combined margin balance in the two markets has skyrocketed by 289 percent, to RMB1.34 trillion. By comparison, during the heady days of March 2000 when the US markets were building to a bubble, the New York Stock Exchange reported margin debt at US$279 billion – up 78 percent in a year. Margin debt in the Chinese markets is thus up almost four times as much.  In 2007, before the crash that the global markets are still recovering from, margin debt was only up 65 percent annually. 

Analysts say the markets remain relatively cheap after the years of slogging slowly upward. But Chinese retail investors, who make up as much as 80 percent of the trading in China, are pushing the rally, which appears to be built entirely on sentiment rather than rationality or research, impelling regulatory authorities to deliver sharply worded warnings to limit lending on margin. Retailer investors tend to react to  “research” from brokers that boils down to the warnings “It’s going up! Don’t wait!”

In 2014, small investors opened 370,000 new trading accounts. With 220 initial public offerings scheduled to come onto the market in 2015, some dilution is almost certain to occur.

This scenario has happened before. In 2007 and 2007, retail investors were mortgaging their houses and borrowing from every possible source to get into the game. It was that crash that was primarily responsible for the long years of caution. Amid rumors that Chinese financial authorities were going to raise interest rates and crack down on speculative trading – trading on margin, in effect – the Shanghai composite fell 9 percent its biggest drop in a decade, and triggering concern in nearly all of the financial markets around the globe.

This trading frenzy is taking place at a time when there is considerable uncertainty about the Chinese market. Property sales, tumbling for months, weakened during the Lunar New Year, with the National Bureau of Statistics reporting that nationally showing that average new home prices fell by -0.46 percent in the month, extending the downturn to 10 months. Both home and commercial sales have fallen by 16.7 percent and 3.9 percent on an annual basis respectively. The unsold inventory for homes is four and a half months, office inventory is nearly 13 months and commercial property inventory is more than 14 months, hitting an eight-month low in February.

The failure of the major property company Kaisa Group Holdings Ltd. to make a coupon payment in early January – apparently related to the political crackdown – sent temporary shivers through the market before it went on a tear again. Shares of the Shanghai-based Glorious Property Holding fell by as much as 35 percent and those of Shenzhen-based Fantasia Holdings Group lost 16 percent of their value. Stocks of other privately owned property companies are also taking a pounding, partly because the economy is slowing, but also over concerns that government investigators may be snooping into corruption. 

With the global economy flat, exports are suffering. Premier Le Keqiang’s pledge to end the year with gross domestic product growth of 7 percent has been greeted with skepticism by many analysts

The traditional signposts are relatively bleak. The steel industry is continuing to produce at high volume although sales are flat, meaning producers will seek to export their overage, driving down global steel prices. According to the Hong Kong-based financial research firm Asianomics, the country is still work its way out what the firm called the “disastrous malinvestment binge..  As with the steel companies, many industries face having to reduce capacity. Last week the government announced it would seek to convert as much as RMB10 trillion in local government financing vehicle debt to bonds. All that probably means tight credit conditions will continue despite the belief that more quantitative easing will be in the pipeline from the central bank.

It could mean that the Chinese punters pouring into the market and borrowing money from their brokers are going to face distress.  It has been pointed out by the investment bank Reorient Securities Ltd. that there is a 10 percent limit down each day. That means the potential collapse is not going to work its way out of the system very quickly.  Watch this space.