Worries of a ‘vicious cycle’ where prices fall, loans are called, stocks are sold and prices fall more.

As stocks in China plumb new lows, global investors can be forgiven for feeling some jitters as they recall the ripples sent through global financial markets by the country’s steep selloff in 2015.

One factor that made that plunge worse, analysts recall, was forced selling by traders who loaded up on leverage, pushing margin debt to a record ahead of the crash. This time around the concern centers on companies and shareholders that have pledged stock as collateral for loans. As in 2015, that runs the risk of kicking off a vicious cycle, in which falling stock prices leads to forced selling as pledged shares are liquidated, in turn leading to further falls in stock prices.

Pledged-share collateral financing “is not small, with estimates ranging from $550 billion to $600 billion,” equal to 10% to 12% of total A-share market cap, wrote Sean Darby, chief global equity strategist at Jefferies, in a note. A-shares are stocks of Chinese companies incorporated on the mainland and listed in Shanghai and Shenzhen.

Chinese stocks felt some heat from forced selling in June after a tightening of monetary conditions. Overall, the small-capitalization Shenzhen Composite Index 399106, -1.92% has declined by 34% from its late-January high, while the Shanghai Composite Index SHCOMP, -2.26%  is down 27% from its January peak. Both benchmarks are in bear-market territory, often defined as a drop of at least 20% from a recent peak.

Chinese stocks fell hard last week then staged the sharpest two-day recovery since 2015, buoyed as government officials attempted to soothe investors. But those reassurances gave way to renewed worries about China’s economic health and the continued trade battle between Washington and Beijing, with Shanghai falling 2.3% on Tuesday and Shenzhen ending 1.9% lower.

China’s downturn appeared to spark a global equity selloff that saw European shares fall and U.S. stocks decline, with the Dow Jones Industrial Average DJIA, -0.50%  falling 548 points at its session low before paring losses to end around 126 points lower, a decline of 0.5%. The S&P SPX, -0.55%  fell 0.6% Tuesday.

There are some important differences between now and 2015, analysts said. For example, authorities appear to be using changes in regulations, including allowing insurers to issue special products to fund listed companies and to alleviate stress, Darby said, noting that local governments have also stepped in to backstop share sales.

UBS analysts Ting Gao and Lei Meng, in a Monday note, pointed to remarks by Liu Shiyu, chairman of the China Securities Regulatory Commission, who last week pointed to several measures aimed at boosting market confidence, including encouraging funds to rescue listed companies with solid outlooks that were facing temporary difficulties due to having pledged shares as collateral.

They also noted remarks by Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission, who called on banking institutions to properly manage risk in their stock-pledge business while allowing insurers to launch special products that would provide liquidity to companies facing pledging-related difficulties.

Using official data, the UBS analysts estimated the amount of shares pledged for collateral at 4.2 trillion renminbi ($605.33 billion), equal to around 10% of total market cap. Around 800 billion to 900 billion renminbi worth of collateral is near the “forced liquidation line,” which they said normally is a collateral coverage ratio of 140%. That’s equal to around 2% of overall A-share market cap or 5% of the free float.

So should investors worry? All in all, the UBS analysts said the situation looks “generally manageable,” but highlighted the potential risk to small- and midcap stocks with high pledge ratios should the selloff continue.

By William Watts
MarketWatch

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