China: An Equity Strategist’s Diary Shadow banking monitor 24, financial system vulnerable to A-share losses Investment Strategy 27 July 2015 Equity Strategy Leverage, inflated collateral & unclear risk responsibility China We estimate that margin outstanding, only from the seven channels that we can estimate reasonably, easily exceeds Rmb3.7tr. Assuming an average 1x leverage, it means that at least David Cui >> Strategist Rmb7.5tr market positions are being carried on margin, equivalent to some 13% of A-share’s Merrill Lynch (Singapore) +65 6678 0411 market cap and 34% of its free float. Meanwhile, A-shares ex. banks are still trading at 36.6x [email protected] 12M trailing PER. We believe that the government will struggle to hold up the market beyond Tracy Tian, CFA >> a few months, unless it is prepared to let go some of its other policy objectives including Strategist Merrill Lynch (Hong Kong) RMB credibility (The A-share market may see another leg down within months, Jul 20). When +852 2161 7632 the market ultimately settles at a level that can be sustained on fundamental reasons, we [email protected] expect that the balance sheet of most financial institutions (FIs) may get impaired and the Katherine Tai >> Strategist financial system may wobble, due to high contagion risk. Merrill Lynch (Hong Kong) +852 3508 7524 [email protected] Leverage means relentless selling pressure The seven channels mentioned above are margin financing (MF), stock collateralized lending (SCL), umbrella trust (UT), stock benefits swap (SBS), structured mutual fund (SMF), P2P and offline private fund matching (Table 1). There are a few other difficult–to-estimate channels, such as banks’ corporate/personal loans that ended up in stocks, brokers’ proprietary desk and funds’ subsidiaries. We suspect that the size of these may be Rmb1-2tr. In addition, China Securities Finance Corp. (CSFC) might have borrowed Rmb1.5tr from banks & PBoC to buy stocks. All the leveraged positions may want to unwind at certain point given the inflated collateral value, in our view. Additional selling pressure may come from hedge funds with compulsory winding-down clauses, when the market heads lower. Balance sheet damage & contagion risk It seems to us that A-shares ex. banks could at least halve, which would only bring down their average PER to just below 20x, before any reasonable case about valuation support could be made. This means that most leveraged positions may suffer from losses ultimately, likely in Rmb trillions. On the other hand, the capital base of brokers and trusts, who are the first loss takers behind investors, is only Rmb1.6tr (Table 2). Banks’ capital may suffer greatly as well once the equity of the other FIs is depleted – banks provide or channel most of the leverage Table of contents: directly or indirectly. The risk is that the unwinding of the leverage will be disorderly – due to • WMP – P13 implicit guarantees behind most shadow banking financial products, investors could easily panic if they suffer from meaningful capital losses, by our assessment. The key risk to our • Trust – P21 view is that the government may be prepared to take on substantially all the leverage, in which case, we expect RMB or growth to come under pressure. • Corporate (LGFV) bond – Shadow banking update P26 Since our last publication in late-Apr, shadow banking activities continued to slow. Total • Price signals – P35 social financing balance growth slowed to 9.2%YoY in Jun, vs +11% in May, +11.8% in Apr and +13.6% in Mar. Correspondingly, sales of WMPs, trusts, and corporate bonds, especially • Shadow banking related LGFV bonds, all showed various degrees of weakness. Given a sizeable portion of shadow news – P39 banking lending likely went to fund stock investment during the covered period, the trend implied a tougher environment for real business borrowers compared to earlier in the year. • Links to our previous reports on shadow banking – P67 >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 70 to 71. 11537386 The Seven quantifiable leverage channels Table 1 summarizes the key figures of the seven leverage channels that we can put some reasonable estimates on. The size of these channels is roughly Rmb3.7tr. Table 1: Key figures of the seven leverage channels Common interest Size cost for borrowers Leverage channel (Rmb bn) As of Sources; basis of estimates Common leverage (p.a.) Main funding sources Margin Financing (MF) 1,455 July 23 China Securities Finance Corp. 1x 8-9% Bank WMP, broker (own fund + TAM) Stock Collateralized Lending (SCL) 901 July 22 Wind; We assume a 40% average 0.3-0.5x 5-13% Broker (own fund + TAM), bank loan-to-asset value loan, trust Umbrella Trust (UT) 621 1H China Trust Industry Associations; 2-3x 9-10% Bank WMP, broker TAM, fund We assume 1) 80% of stock related TAMC, P2P, offline private fund trust AUM increase since mid-14 is matching firms, HNWIs, for UT; and 2) 2Q15 increase in such corporations AUM = 1Q15's. Stock Benefits Swap (SBS) 123 1Q Securities Association of China 2-4x 8-10% Broker (own fund + TAM), bank WMP Structured Mutual Fund (SMF) 473 1H Fund Industry Association 2x 8-9% Retail P2P 20 1Q Securities Times article on March 3x 18-20% Retail 9th, citing local experts' estimate Offline Private Fund Matching 150 1Q As above 2-10x 15-20% Retail & HNWIs Subtotal 3,743 Source: Various news, BofA Merrill Lynch Global Market Margin Financing (MF): Rmb1,455bn This is the most transparent part of the leverage in the stock market with CSFC announcing the outstanding balance on a daily basis. The balance peaked on Jun 18th at Rmb2,267bn and has since declined to Rmb1,455bn by July 23rd (Chart 1 & 2). Chart 1: Margin purchase as % of daily turnover Chart 2: Margin trading balance as % of A-share market cap 24% 2,400 5% Margin trading outstanding, Rmb bn (rhs) Margin purchase as % of daily turnover (lhs) 20% 2,000 4% 16% 1,600 3% 12% 1,200 2% 8% 800 1% 4% 400 0% 0 0% Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-13 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Apr-12 Oct-14 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Jan-11 Jun-11 Mar-10 Mar-15 Feb-13 Nov-11 Dec-13 Aug-10 Sep-12 May-14 Source: WIND, BofA Merrill Lynch Global Market Source: WIND, BofA Merrill Lynch Global Market This is likely the safest part of the leverage as well because the government has kept a fairly tight control over the leverage ratio – for example, brokers will call for additional margin if an account’s Collateral Maintenance Ratio, defined roughly as market value/margin financing, falls below 130% (Margin call - it's what we don't know that matters, Jun 30). That said, we don’t believe that the leverage here is completely safe because 1) average entry level for MF 2 China: An Equity Strategist’s Diary | 27 July 2015 positions can be quite high judging from the large size of the daily buying activities financed by margins, often in hundreds of billions of Rmb; and 2) the government had allowed brokers to loosen margin requirements in recent weeks as part of its efforts to stabilize the market (Table 1, The A-share market may see another leg down within months, July 20). MF is largely funded by banks via bank wealth management product (WMP) and brokers via their own funds and their Targeted Asset Management programs (TAM) – Exhibit 1. Although the government forbids banks to directly lend for stock purchase, it allows banks to do so indirectly via WMP because, in theory, banks do not bear losses if WMP loses money (more on this latter), and buyers of WMP are supposed to be reasonably sophisticated. Exhibit 1: How MF is funded Source: BofA Merrill Lynch Global Market CSRC limits a broker’s MF balance outstanding to 4x of its net equity. Stock Collateralized Lending (SCL): approx. Rmb900bn Holders of listed stocks can go to brokers, banks and trust companies to obtain a loan, using the stocks as collateral. Although in theory the borrowers can use the obtained funds for many purposes, we suspect that in recent times most of them used the funds to invest in the stock market, sometimes by buying the very stocks they used as collaterals to drive up their prices. It appears to us that potential margin calls from this lending source is one of the main reasons why, at the height of the A-share market crash, close to half of the A-share companies had their stocks suspended from trading (Chart 1, The A-share market may see another leg down within months, July 20). Based on data from Wind, we calculate that the outstanding value of stocks being collateralized, based on the value on the date of collateralization, reached Rmb2,253bn by July 22, up from Rmb1,475bn at the end of June 2014.