Easy credit feeds risky margin trades in Chinese stocks

Getty Images

"High leverage, low thresholds!" the website says. "(China's) A shares are heating up; if you don't allocate capital now, then when?" Many, it appears, are choosing now, gorging on cheap credit to ride a wild stock market rally.

The website, Jinfuzi.com, will let investors borrow up to 10 times their principal with only 2,000 yuan ($323) down in order to buy stocks and futures.

The peer-to-peer lender has an easy sell; Chinese benchmark indexes have posted record-smashing trading volumes in recent weeks, with average share values up over 30 percent in just 12 trading days.

Ordinary investors, who conduct 60-80 percent of China's stock trades, charged into the market after a surprise interest rate cut by Beijing on Nov. 21, and brokerages and shadow bankers have rushed in to help them trade on margin - essentially borrowed money.

Chinese reforms tightens use of bonds
Chinese reforms tightens use of bonds   

"Margin trading has clearly played a big role in the recent rally, and government is worried," wrote Oliver Barron of NSBO in a research note on Tuesday, estimating that gross margin trading purchases accounted for 164 billion yuan ($26.5 billion) on Monday, the equivalent of 17 percent of total turnover on Chinese bourses.

Read MoreChina's 2015 outlook in three words

There has been a steady relaxation of restrictions on margin trading in the last two years, and while in good times it allows investors to make a lot of money with only a small amount of their own cash, it also carries big risks when the market falls.

Some might already be regretting taking those risks after the Shanghai Composite Index lost over 5 percent on Tuesday, its largest single-day drop in five years.

Especially those who might have pledged their property to get in on the rally and offset the slide in house prices.

"We provide our customers with service to borrow money with their property as collateral," said Mr. Yu, president of Qianteng Asset Management Company in Hangzhou.

Read MoreChina trade data paints dreary picture of economy

"We have plenty of funds on hand, which makes it easy for our customers to get money ASAP once they sign the contract."

Yu declined to say how his company assesses the chances of borrower default.

Analysts worry that China's financial industry generally lacks rigor in risk assessment and due diligence.

Margin trap

In a volatile market, it is much easier for small investors to get caught out.

Read MoreChina shadow bank collapse exposes grey-market lending risk

"The swings in the market are up 1, 2 percent, down 3, 4 percent; it's chaos," said Thomas Gatley, analyst at Gavekal Dragonomics in Beijing, who believes the leveraging was at least partly to blame for the increased volatility.

"Depending on what you've bought on margin, you get cash-calls. So you get a lot of people jumping in and a lot of liquidity flowing ... into a stock or group of stocks. If the price on that falls at any point for say 5 or 6 percent, then all the people who bought that will get a call from their broker to say 'You need to pay some more cash or you need to sell right now.'"

The stock market rally is nevertheless welcome in many quarters. Certainly to listed companies, and the many queuing to list, but probably also to Beijing, which is grappling with a slowing economy and fears the housing slide could further dent consumer sentiment.

Read MoreChina advisers recommend 7% growth goal in 2015 as leaders meet

But governments prefer more orderly markets. Some said Tuesday's sharp market correction was partly a reaction to a regulatory crackdown on the use of leverage in the corporate bond market, to prevent corporates converting bond issuances into cash to plough into stocks.

Such behavior was widely blamed for a similar stock market rally in 2009, when many companies and individuals took advantage of cheap stimulus credit to speculate on shares and housing, which caused share indexes to double before suffering a bone-rattling crash.

Even after the current rally, Chinese stock indexes have yet to recover from that crash; the Shanghai Composite Index is still down 12 percent from the peak hit that year, and 48 percent from their pre-financial crisis high in 2007.