China stocks head for worst week in over a year as small-cap woes bite

SHANGHAI, Feb 2 (Reuters) - China stocks are heading for their worst week in over a year, as a sell-off in small-caps ripples across the broader market amid a perfect storm of events including an executive's suicide, huge corporate losses and a shadow banking squeeze.

Over 40 companies suspended trading on Friday to avoid margin calls, while an increasing number of firms announced share purchase schemes by shareholders, stirring memories of a wild sell-off two years ago, when shares slumped amid fears of an economic slowdown and capital outflows.

The benchmark Shanghai Composite Index recouped early losses on Friday to edge up 0.2 percent, but was still poised to post a weekly decline of roughly 3 percent, its biggest percentage loss since December 2016.

The blue-chip index CSI300 has tumbled 2.7 percent this week.

At the epicenter is ChiNext, China's Nasdaq-style start-up board. The gauge has lost around 6 percent this week, the worst performance in 21 months.

Investor faith in small caps has been shaken following a wave of profit warnings and an eye-popping $1.8 billion annual loss flagged this week by struggling Leshi Internet, formerly seen as a ChiNext bellwether.

David Dai, general manager of Shanghai Wisdom Investment Co Ltd, said he no longer dares buy small caps amid increasing signs of "bloodbath accounting," where companies unexpectedly conduct massive write-offs during bad years to wash the books.

"There's a real danger of stepping on the landmines, as companies seem to be able to change their accounting treatment at will," Dai said.

"Many growth companies nowadays cannot even outgrow bluechips such as Moutai," he said, referring to the Chinese premium liquor maker that predicted a 58 percent profit surge in 2017.

According to an estimate by GF Securities, combined profit of ChiNext companies dropped 5.5 percent in 2017, compared with 7.8 percent growth at Chinese banks.

Dai also expressed concerns over an upcoming wave of margin calls if share prices fall further, which could tighten liquidity conditions even as regulators expand their campaign to reduce risks in the financial system.

Highlighting the rippling effect, the death of Zhejiang Jindun Fans Co's Chairman Zhou Jiancan this week triggered rumors of a failed investment in Leshi, whose shares have been in a free-fall.

The company said on Thursday that Zhou's death was not related to the alleged Leshi investment.

But it disclosed that nearly all of Zhou's holdings in the company - roughly 26 percent of total shares - are pledged against loans, and that his son will be responsible for dealing with margin calls if they're triggered by further price falls.

In an apparent effort to avoid forced selling, roughly 40 companies, including Shenwu Energy Saving Co and Tainguang Zhongmao Co suspended trading on Friday following share price tumbles.

The growing list of share suspensions echoed those which were seen during the 2015 market crash, which drew criticism from global investors as to whether China was truly commited to free market reforms.

U.S. stock index compiler MSCI has complained that China is an "outlier" in having too many, and too frequent trading halts. It will include China's "A-shares" into its emerging market benchmark starting June.

According to an estimate by Sinolink Securities, as of Jan 31, 1,066 cases of margin calls had been triggered, involving shares in 608 listed firms.

Adding to the selling pressure is Beijing's stepped-up campaign against shadow banking, which is forcing the closure of many wealth management schemes.

And after sharp gains in recent weeks, many investors may be simply taking profits ahead of the long Lunar New Year holidays beginning in mid-February.

"The sell-off in Shenzhen is testing the grit and patience of investors, many of whom will collapse before dawn," Zhang Mingyu, fund manager of Shanghai JY Investment, wrote in a note to clients.

"But if you manage to wade through the swamp ahead, you can stand up on land." (Reporting by Samuel Shen and John Ruwitch; Editing by Kim Coghill)