DOMESTIC banks seeking to profit from the country’s stock market frenzy have bought into the recent surge in margin finance, foiling regulatory efforts to reduce debt-fueled speculation and amplifying the risk if the rally turns into a rout.

    Although regulators are cracking down on credit flows into the stock market, financial industry insiders say they still have not closed loopholes that allow banks to channel credit into the stock market via brokerages.

    That exposes China’s banking system to greater risks, even as lenders struggle with an economic slowdown that has pushed up bad loans, but market watchers say it is not time to panic yet.

    “I estimate that around 18 to 20 percent of margin finance loans end up with banks, but it varies from brokerage to brokerage,” said a senior brokerage auditor at one of the big four accounting firms in China. “It is definitely growing.”

    The easiest way banks get into margin financing is by treating margin loans made by brokerages to investors as collateral for loans to the brokerages themselves. This creates a quick profit for banks and frees up brokerages to lend more.

    Brokerages are obligated to buy the collateral back from the banks, but that becomes a major problem if the market collapses as it did in 2009, after another liquidity-fueled rally.

    Despite a 40 percent jump since November, the current rally has still not returned indices to their 2009 peaks.

    The broader impact of the 2009 implosion was limited because most of the speculation was done with cash, not credit. But China has lifted restrictions on margin financing since then.

    “The economic risk to the equity market is that China’s growth is still decelerating,” wrote Jonathan Garner and Lara Wang of Morgan Stanley in a research note. Margin finance was another risk because it could amplify downward moves as investors sold out to protect their collateral, they added.

    The margin credit balance in Shanghai is about 3 percent of total market capitalization, compared with the last reading of 1.8 percent for the New York Stock Exchange in November.

    China has punished some brokerages for bending the rules, and drafted new rules targeting banks. But apart from a one-day plunge the day after the announcement, from which markets have already recovered, there has been little sign that investors, bankers or brokerages are intimidated.

    The outstanding value of borrowing for margin trading hit 776 billion yuan (US$124.30 billion) on the Shanghai Stock Exchange on Jan. 26, according to exchange data, and those figures do not include other forms of financing.

    There are many variations on the theme, however.

    Some banks accepting margin finance loans as collateral are repackaging them as wealth management products (WMP), which are sold to retail customers. Major banks, including Agricultural Bank of China, have gotten into the act along with smaller ones like Dongguan Bank, which if offering a WMP with an annualized rate of return of 5.5 percent and a guarantee on principal.

    The government does not want to stop margin financing entirely, as stocks are one of the few bright spots in China, so there is strong political pressure not to trigger a market collapse.

    “They are still quite happy to see the use of margin in the markets increasing over time,” said Jonathan Garner of Morgan Stanley, who said the usage of margin finance was healthy.

    For the government, with an eye on the history of other asset bubbles, the challenge will be balancing the two.

    “Anytime credit growth is excessive and goes on for too long, there are broader risks,” said Tim Condon, head of Asia research of ING in Singapore.

    (SD-Agencies)