Imagine an investor losing $16bn in just 24 minutes. Sounds incredible, but that is exactly what had happened in May, setting the stage for a 33pc meltdown in the Shanghai market in three weeks.
It had all started with Hanergy, the world’s largest solar energy company listed on the Hong Kong Stock Exchange. Li Hejun, its controlling shareholder, lost about $16bn in just 24 minutes of trading. This subsequently triggered panic among investors and mainland Chinese brokerage firms, which are famous for margin lending.
Such lending was akin to the ‘badla’ system that was prevalent in our markets prior to the crash of 2008. Karachi-based investment expert Mir Mohammad Alikhan explains that it is common in Chinese markets for investors to borrow up to 90pc of their funds in some cases to buy shares.
So when the brokerage firms, which themselves had borrowed money from banks, saw the market value of a big company like Hanergy plummet in a matter of minutes, they started to fret about the funds they had lent to their own investors.
“This borrow-and-invest practice created 80m investors in China within two years — the largest number of investors created in such a time span in the history of capital markets.” And with nine out of 10 Chinese investors using borrowed money, this was a disaster waiting to happen. As soon as the brokerage firms started making ‘margin calls,’ panic spread amongst the investors, who started to sell their holdings, ultimately leading to the Shanghai market crash.
In many respects, the picture in China resembles the multiple crises that hit the Pakistani capital market in the first decade of the century. But since the regulators here scrapped the ‘badla’ system, the market has moved towards more cash-based investments.
Although ‘badla’ has been driven out of the stock market, most market participants are aware of brokerage houses that still allow a select few investors to borrow as much as 65pc to invest in equities
Yet, there are still some disconcerting thoughts on other sources of borrowings that could arguably be used to invest in speculative assets. Since last November, the State Bank of Pakistan has reduced interest rates by 300bps to 7pc, its lowest level in over a decade. In a low inflation scenario, the SBP had little choice but to trim the discount rate. The industrialists celebrated this as a major factor that would help them ‘reduce their cost of doing business’.
Meanwhile, economists suggest that the low discount rate would spur credit demand, which could both be a boon or a bane for the economy.
“It is difficult to shake off the uneasy feeling that corporates could resort to borrowing not merely to reform and restructure their balance sheets, but to put money to speculative use,” said a senior analyst. He pointed out that such a phenomenon had occurred in a similar situation in early 2000, and identified two major speculative investment avenues as stocks and real estate.
Another economist pointed out that the low interest rate policies pursued by the US Federal Reserve during 200-2004 had exacerbated the housing and commodities bubbles. The housing bubble popped as the subprime mortgages began to default at higher-than-expected rates, coinciding with the Fed raising its federal funds rate.
“The money managers and regulators should monitor the trail of cash from banks, and this should not lead to speculative assets,” said this economist.
But Khurram Schehzad, director research and investment strategy at Arif Habib Limited, argued that it was too early to worry about asset bubbles created by the use of borrowed money for investment.
“Such a situation occurs when the economy actually heats up.” For the moment, corporates are using their own funds to restructure and repay bank loans. Notices filed by companies at the Karachi Stock Exchange suggest that bank borrowings are being used by the private sector for productive purposes, including expansion and diversification.
Schehzad insisted that the market liquidity is being generated internally as the stock prices continue to sour.
“The KSE’s market capitalisation, which used to be around $38bn two-and-a-half years ago, has climbed to $76bn, and the cash generated is further fuelling the stock price rise. Besides, much of the liquidity in the market is a result of foreign portfolio investment, as foreigners now hold as much as 34pc of the market float against just 18pc in 2008.”
Muzammil Aslam, CEO of Emerging Market Research, also believes that private sector credit off-take is low, since the funds are generally available at Kibor + 2pc, which is on the higher side.
“Moreover, the strict lending criteria set by the SBP do not make it easy for banks to offer cash for speculative investment.”
He believes that liquidity is also flowing into the market as investors who had parked their money in bank deposits and National Savings Schemes are shifting to equity for higher returns.
Nothing could be more effective to prevent the formation and the inevitable bursting of bubbles than cash investment by investors. Although ‘badla’ has been driven out of the stock market, most market participants are aware of brokerage houses that still allow a select few investors to borrow as much as 65pc to invest in equities.
Alikhan suggests that the source of funds for investment in stocks should be put under stringent regulations. He believes that 50pc cash and 50pc margin would be suitable for now, but it ought to be raised to 70pc cash and 30pc margin.
“Margins should be kept on the slope as the index value goes up, with a view to ultimately head towards an all-cash market. Those who would buy on cash would not panic, and they could also not be forced to sell to pay margins calls if the market takes a tumble.”
Published in Dawn, Economic & Business ,July 13th, 2015
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