A red flag in China's unstoppable market rally

Carlos Barria | Reuters

The unstoppable rally in Chinese stocks has been accompanied by a sharp rise in margin financing, giving rise to concerns about the market's stability.

Margin balance - a measure of investor leverage - as a percentage of total market capitalization of A-shares stood at 2.4 percent at the end of 2014, among the highest in the world and on par with the New York Stock Exchange (NYSE), according to Bank of America Merrill Lynch.

The use of margin financing has risen at an exponential rate in China, compared with the NYSE. For the NYSE, the ratio rose from 0.9 percent to 2.4 percent over 13 years. It took A-shares just 17 months – from July 2013 to December 2014.

"This is the first major market rally in China backed by margin financing," David Cui, strategist at Bank of America Merrill Lynch wrote in a note, adding that many investors have not yet experienced leverage working the wrong way.

The benchmark rallied over 50 percent last year, its best annual gain in five years, as retail investors – who account for around 80 percent of trading volume - piled into stocks.

"Leveraged speculation often gives investors and lenders a false sense of security, because, for a while, it can be self-fulfilling. However, when investors are forced to unwind due to margin calls, liquidity in the market can evaporate rather quickly," he said.

"So, despite a seemingly high down-payment ratio, margin lending is not safe, in our view, which may have implications for brokers and banks at some point," he added.

Risky business

Other analysts have also pointed to the rise in margin financing as a risk for the market.

In a note published last week, Wendy Liu, head of China equity research at Nomura, who is overall bullish on the outlook for the A-share market, wrote: "Data on margin financing activities show that the year-end surge in A-shares was partially fueled by borrowed money. This is a risk factor to consider as we head into the expected bull run of Chinese equities, given that such leverage positions are likely to be shaken out in occasional market pullbacks, which could aggravate declines in stock indices."

Stuart Rae, chief investment officer for Pacific Basin equities at AllianceBernstein is less concerned.

"Most markets around the world have a degree of margin trading. [In China], it's not big enough in absolute terms to cause a problem for the financial system," Rae said.

"It's just sort of highlighting what drove the market, which was this huge rush of retail money - and some of that retail money is borrowed," he added.

Stephen Sheung, head of investment strategy at SHK Private says there are other trends in the mainland market that are more troubling than the rise in margin financing.

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The rise in margin financing isn't the primary reason more funds are entering the market, said Sheung. Instead, retail investors are going through a rebalancing process – shifting away from assets such as real estate or wealth management products – into the stock market.

Two more alarming trends for the market in the short-term are the decline in trading volume since mid-December, and slowdown in the opening of new brokerage accounts in recent weeks, he said.

These trends signal there could be a small consolidation in the market to the 3,000 level before it continues on its uptrend, Sheung said. The Shanghai Composite traded around the 3,258 level on Monday.

CNBC's Leslie Shaffer contributed to this article.