Carnage in China's Stock Market as Margin Calls Trigger Panic Selling

China’s stock market underwent a harrowing session on October 11th as a perfect storm of factors converged to send shares tumbling. The Shanghai Composite Index sank 2.55%, breaching the psychologically important 3,200 point support level. The Shenzhen Component Index and ChiNext Index, which tracks tech and growth stocks, led the decline.

Across the market, 4,800 stocks ended the day in negative territory, while a mere 400 managed gains, painting a picture of broad-based selling. Several sector-specific concepts that had previously attracted speculative interest, such as cross-border payments, medicine and biotech, experienced sharp reversals.

The impetus for the aggressive sell-off appears to lie in an uptick in margin calls, where brokerages require investors to put up more collateral for their leveraged positions or forcibly liquidate holdings to cover losses. As highly leveraged investors rushed for the exits, their selling begat more selling in a vicious negative feedback loop.

Data from listed companies reveals an unsettling trend in the lead up to this rout. In just the week from September 23rd to 30th after the China Securities Regulatory Commission (CSRC) announced easing measures, 87 companies disclosed major shareholders' plans to reduce holdings, double the preceding week’s figure. By October 8th, a further 95 companies had unveiled such plans.

Among those lining up to cash out were a number of state-owned enterprises and institutions, including Central State-owned Capital Operating and Investment Fund, several industry-specific national investment funds, and even the NSSF. One major shareholder alone dumped 1 billion yuan worth of shares. This ‘rat fleeing a sinking ship’ dynamic no doubt sapped retail investors' confidence.

Foreign institutional investors also seized the chance to exit. Morgan Stanley, Goldman Sachs and others featured prominently among the top 10 brokerages with the heaviest net selling on October 11th. Chinese institutions like Guotai Junan Securities and CICC also made the list, suggesting little discrimination in the rush for the door.

In a telling contrast, data indicates that over 90% of the millions of new trading accounts opened during the October holiday golden week belonged to young, novice investors born after 1990. Many lined up at brokerage offices even on the public holiday, eager to deploy funds and ride the bullish wave - right into this massacre.

The CSRC’s move to allow more leverage and entice fresh capital into a slowing market has in effect led lambs to the slaughter as big money used the liquidity to cash out. For the new entrants who bought into a hyped-up narrative of a new bull market, this baptism by fire serves as a brutal lesson in the zero-sum game of short-term trading.

Ultimately, this episode throws into stark relief the tug-of-war in China’s financial markets. Regulators seek to shore up the market and economy with easing, while sophisticated players exploit windows to exit, leaving retail holding the bag. Until structural issues around risk controls and investor education are addressed, wealth redistribution from the many to the savvy few seems set to remain an endemic feature of the Chinese stock market.