The Shanghai Composite falls 6 42 per cent

On Friday (June 19th), investors watched Shanghai equity values evaporating before their eyes as the combination of a liquidity crunch and profit-taking cut the benchmark Shanghai Composite Index by 307.00 points, or 6.42 per cent, to 4,478.36.

A regulatory glare on excessive margin lending has been touted as one factor that has forced investors to unwind bullish positions.

Last week the China Securities Regulatory Commission (CSRC) warned brokerages not to extend or facilitate illicit loans to clients for share purchases, according to Reuters. The CSRC also asked them to “conduct self-inspection,” and said it would exercise more vigilance on margin financing and short-selling activities. 

Brokerages have also been asked to conduct stress tests and invest in reliable trading systems.

The regulator is seeking to avoid a market disruption and losses to retail investors due to overexposure to equities through the medium of borrowing on margin. 

CSRC also released draft rules that cap a brokerage's margin trading and short selling business at four times its net capital.

The recent torrent of IPOs has also soaked up liquidity from listed Shanghai stocks. Nine issues hit the market on Friday, prompting investors to cash in profits on listed stocks and reinvest them in the IPO market.

Worst week since the financial crisis

Friday’s trading capped off the worst week for the Shanghai Index since the days of the global financial crisis. 

The index lost 13.3 per cent for the week, amidst a continuing correction from the June 12 peak. A rally that commenced in November with a rate cut that propelled Chinese stock markets to the top of the world stock market performance table. 

The Shanghai stock market has more than doubled over the past year, even though economic fundamentals do not justify the rise. It appears that margin borrowing, investor exuberance and monetary easing have together combined to push up Chinese stocks to stratospheric levels, with a correction all but inevitable.

"Recently, elements that curbed the market's rise are emerging," Bosera Asset Management Co said in an email, according to Reuters. "First…room for further monetary easing could be less than anticipated, and inflows of new investors could have peaked. Secondly, a highly-leveraged bull (market) is not sustainable."