The blame game

Completed in 1916, the Asia Building in Shanghai enjoyed the city’s most prestigious address: No. 1 the Bund. Later the Asian headquarters of the oil giant Shell, it currently houses China Pacific Insurance. But it was actually built by the British merchant George McBain, who is said to have made a killing on the Shanghai market before a spectacular crash in 1910.

At the time Henry Ford had just begun mass-producing his Model T cars. Rubber prices had surged, as had the profits of rubber producers. In Shanghai groups of foreign financiers set up rubber firms – claiming to have production bases in Malaysia, but in reality with little operational experience – and sold shares in them on the local bourse. Money from all over China flew into these rubber stocks. A lively derivatives and short-selling market also developed.

The standout performer was McBain’s Langkate, fuelled by lavish advertisements in Shanghai’s newspapers, even though McBain was yet to grow a single rubber tree. Langkate’s share price surged tenfold in less than a month after its debut.

In June 1910 the euphoria came to an abrupt halt after restrictions were impsed on rubber imports to the United States. Rubber stocks crashed, bringing down Shanghai’s stock market, as well as a large number of Chinese lenders. (The Qing government tried to intervene by holding local brokers accountable, accusing them of helping speculators to short-sell the market.)

But the punitive action was unable to prevent an unexpected twist. A government official had invested heavily in Langkate with public funds earmarked for a railway in Sichuan. The Sichuan firm was forced to sell its track to foreign investors. The move triggered protests in the vast province, which in turn led to the revolution of 1911, and the eventual fall of the Qing Dynasty (see WiC282).

According to today’s Chinese media, this was the “stock crisis that felled an empire” and the episode has been recalled in recent weeks as a reminder of the consequences of mishandling a financial crisis.

Perhaps the historical precedent also explains why regulators have unleashed a fierce campaign against the present-day short-sellers and market manipulators they claim to be responsible for the meltdown that has wiped out nearly half of the value of the A-share market since June.

Who has been identified so far?

The first salvo came from an editorial published by the Financial News against “foreign crocodiles” (a term taken from the Hong Kong media, which originated in the Asian financial crisis).

Titled “Fight malicious short-selling without delay”, the PBoC-run newspaper singled out the American firm Morgan Stanley, for making “malicious remarks carelessly” and harbouring “ulterior motives” in reversing its previously bullish forecasts on Chinese stocks.

“Why are the international investment banks fluffing the rain clouds?” Financial News asked. “For the interest groups behind them or to short-sell maliciously in order to disrupt China’s economic reforms?”

Unnerving China’s foreign investment community further was speculation that Li Yifei, the chairwoman of the London-listed hedge fund giant Man Group’s China operation, had been taken into custody last week. Remarks from Li’s husband, who told reporters the businesswoman had been locked in meetings with regulators in Beijing, added to the confusion.

Li then emerged from her mysterious week-long absence this week, posting on her weibo that she had attended “industry meetings” but also telling the Financial Times she had then gone to the mountains to meditate, switching off her phone over the weekend.

The quest to hunt down offenders in the domestic securities industry has been fierce. Several local brokerages have been mired in the regulatory probe but Citic Securities looks to have been the worst hit. China’s biggest brokerage now has eight executives detained for investigation. Their offences are not yet known, although Xinhua has reported on rumours that they “ganged up with foreign hedge funds to short-sell Chinese stocks”.

The state-run Securities Daily reported that other homegrown institutions have been colluding with foreign investors to take advantage of the central government’s stock market interventions to make gains.

Rumours then began to spread that Citic Securities chairman Wang Dongming had fled to the US, forcing the state-owned giant into a statement rebuffing the speculation. Wang’s brother Wang Boming, the founder of influential financial magazine Caijing, might have lost some sleep too. A journalist from Caijing was arrested and paraded on state television last month, leading to an on-air confession. His wrongdoing? He wrote a story in July that claimed that the China Securities Regulatory Commission (CSRC) was pondering a halt to its interventions, which were aimed at jacking up the market.

Adding to the list of bogeymen were 197 internet users accused of spreading rumours; several executives at listed firms alleged to have insider-traded; and even two former officials from the CSRC itself.

Regulators have also suspended a number of trading accounts as part of their probe into what they have labelled as potentially “malicious” short-selling.

Unhelpfully there has been little attempt to define publicly what “malicious” behaviour actually entails. But the only foreign account thus far affected is the China unit of Citadel. (The domestic media has been quick to point out that the Chicago-based investment group is being advised by a certain Ben Bernanke.)

In what ways can investors short-sell Chinese stocks?

Until 2010 the A-share market was a one-way bet (i.e. you could go long only), but that changed that year when pilot programmes were introduced to allow bearish bets in the equity market.

More sophisticated derivatives have been developed since then. For example, the first option trading product was launched in Shanghai in February. This ETF-based (exchange-traded fund) option tracks the SSE50 index, or 50 of the most heavily weighted stocks on the Shanghai bourse, and offers investors a hedging tool for trading the index heavyweights. (Options on individual stocks, or put warrants, were permitted briefly in 2011 but then withdrawn by the authorities on concerns of excessive speculation.)

The second channel for short-selling is via the Shanghai-Hong Kong Stock Connect, which has allowed investors in either city to invest in the other’s market since last November. A total of 414 Shanghai stocks – out of 568 designated forthe Stock Connect scheme – are available for short-selling. But the daily limit for each stock is small: capped at 1% of the holdings of all foreign investors through Stock Connect. Brokers also have to file their short position reports every week. “Their trading is not only peanuts in terms of size but also heavily restricted, so it can’t call the market’s tune,” the South China Morning Post has noted.

Then there are index futures. The first of these contracts, which tracks the large-cap CSI300 Index, was introduced in April 2010. It was not until this April that two more products – based on the CSI500 Index and SSE50 Index – were added to the short-selling toolkit, as regulators moved cautiously to expand the range of financial derivatives open to investors.

A final means of going short: investors could leverage their bets with margin financing. This practice was permitted as far back as 2010, but interest was dormant until last year’s bull run in stocks gained steam. By mid-June, at the peak of the A-share market rally, Chinese brokerages had extended nearly Rmb2.26 trillion ($354 billion) worth of margin loans.

These investors would have accounted for the bulk of the short-selling market.

As compared with these short-selling channels, the actual amount of investment foreign fund managers are allowed to have in Chinese stocks (mainly through the QFII and RQFII schemes) remains small. Former World Bank president Robert Zoellick estimates it accounts for just 1% to 2% of the entire A-share market.

“It is hard to imagine how foreign investors could have such a big effect,” Sina Finance has also admitted, countering the idea that it was ‘black hands’ from overseas that sabotaged the market in mid-June.

Are regulators now shutting the short-selling windows?

Not exactly. But they are trying harder to make the rules of the game less exciting. Tightening measures have been announced by different regulators this week to reduce market volatility. For example, the Shanghai Stock Exchange (SSE) said on Monday it would tighten limits on the positions of ETF stock options linked to its SSE50 Index. On the same day, the Shenzhen Stock Exchange (SZSE) and the China Financial Futures Exchange (CFFEX) also began discussions on a planned circuit breaker mechanism. According to the draft regulations, trading could be suspended for 30 minutes if the market rises or falls by 5%, and for an entire day if the volatility exceeds 7%.

“Circuit breakers in both directions will be conducive to curbing excessive transactions and reining in market fluctuations,” the draft document suggested.

Also starting from Monday, the CFFEX began to label a position of more than 10 contracts on a single index future as “abnormal trading” (the standard was earlier lowered from 600 to 100 in late August). Margin requirements for non-hedging contracts are also to be raised to 40% from 30%, while fees for settling positions that were opened on the same day will double too.

As a result, Bloomberg notes, volumes in both CSI300 Index futures and CSI500 Index futures sank to record lows this week. The Chinese market was ranked by the World Federation of Exchanges as the most active for index futures as recently as July, but has since plummeted 99% from that peak (when more than 3 million contracts a month were traded). “China just killed the world’s biggest stock-index futures market,” Bloomberg has proclaimed.

The process of deleveraging has also been spectacular in the margin financing business. Outstanding margin loans on the SSE and SZSE had nearly halved to Rmb1.25 trillion by the end of last month from their peak in June. The figure continues to shrink, dropping to Rmb962 billion last week. “The regulators’ objectives [to stamp out excessive short selling] have been largely achieved… the process of deleveraging should be coming to an end,” CBN, a newspaper, commented this week.

Meanwhile, the Chinese government is boosting efforts to keep more money at home. Major state lenders such as Bank of China are beefing up their internal checks on large conversions of foreign exchange by corporate clients, according to Chinese banking executives. And there were no new quotas for Chinese residents to invest overseas via the QDII scheme for a fifth month running in August, the longest halt in six years. Meanwhile the Ministry of Public Security has started a campaign to crack down on underground banks and illegal cross-border money transfers too. The day after that announcement was made, Hong Kong’s benchmark Hang Seng Index plunged more than 1,000 points.

Is it fair to target short-selling?

In the first half of the year – when the A-share market was on a rationality-defying winning streak – the prevailing sentiment was that a major correction was long overdue. But the extensive efforts to apportion blame for the subsequent rout has unnerved foreign investors, especially those that have received the dreaded invitation for “a fact-finding chat” with the market regulators in Beijiing.

A big US hedge fund with operations in China told the Financial Times that it is now conducting extra audits of its trading activity, because of concerns that the authorities are imposing additional scrutiny on foreign investors.

An executive at the fund told the Financial Times: “Are they [the authorities] going to decide that malicious short-sellers brought down the market? Are they going to create a witch-hunt? It is hard to tell because they are so unpredictable.”

Other markets, including the US and countries in Europe, banned short-selling of shares in banks and brokers during the global financial crisis of 2008. But these interventions might well have backfired, as regulators in the West would later admit. “The costs appear to outweigh the benefits,” Chris Cox, the former chairman of the US Securities and Exchange Commission, later acknowledged.

Back in China the damage may take longer to rectify. Many foreign investors are taking the view that the hostile mood is a clear step back from Beijing’s earlier and highly-publised commitment to freer markets and further reform. Additionally, the limits on short-selling are sapping liquidity and removing a key source of demand for times when markets are in freefall, (short-sellers must trade to square their positions and take profit).

Right now the instinct of the authorities is to cage volatility. It’s understandable, but it has an unwelcome consequence: the era in which the Shanghai and Shenzhen bourses play a more meaningful role in allocating investment capital now looks to be much further off…

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