STOCK forecasters in search of an early-warning system for the next Chinese bear market are zeroing in on the country’s record US$358 billion pile of margin debt.

    When that three-year build-up of leveraged positions starts to unwind, regulators will struggle to limit the selloff, according to Bocom International Holdings Co. and Rabobank International.

    Almost all of this year’s biggest declines in the Shanghai Composite Index, including a 6.5 percent slump May 28, were sparked by investor concerns over margin trading restrictions. The securities regulator announced plans Friday to limit the amount brokerages can lend for stock trading.

    “There’s definitely a ceiling on margin lending,” said Wu Kan, a Shanghai-based fund manager at Dragon Life Insurance Co., which oversees about US$3.3 billion. “Once leveraged investors begin to cut their holdings, it means they’ve turned cautious on the market and that will probably spark a correction.”

    A pullback by margin traders would undercut one of the biggest drivers of the rally that’s lifted the value of shares to more than US$10 trillion for the first time. With so much borrowed money at stake, market downturns run the risk of snowballing as traders are forced to sell shares to meet margin calls, said Anthony Neoh, a visiting professor at the National University of Singapore and member of the Chinese securities regulator’s international advisory body.

    The Shanghai Composite tumbled May 28 after a brokerage increased its margin requirements, or the collateral put up by investors when borrowing to buy shares. The gauge plunged 7.7 percent Jan. 19 after a regulatory suspension on new margin accounts at some of the nation’s biggest securities firms. On both occasions, the index recovered within days as margin loans kept climbing.

    Hao Hong, the chief China strategist at Bocom International, said policymakers face a choice: enact margin curbs and bring an end to the bull market, or let leverage keep growing and risk an even bigger market crash down the line. They also have to contend with loans that make their way into the stock market through China’s shadow finance sector.

    “The regulator is trying to slow down the growth without triggering panic,” Hao said. “If margin loan growth starts to decelerate notably, the market will slow down. If non-compliant margin lending accounts must be closed, the market will crash.”

    The China Securities Regulatory Commission (CSRC) is planning to curb the amount of margin finance and short selling to no more than four times a brokerage’s net capital, according to draft rules posted on its website Friday. There is currently no ceiling.

    The CSRC is also considering allowing brokerages to roll over margin trading and short selling contracts, instead of closing them out after six months, which may quell volatility if the rally falters.

    “Guiding markets like this with regulatory measures is incredibly hard to do,” said Michael Every, the head of financial markets research at Rabobank International in Hong Kong.

    China’s stock market tumble of 2008 shows how quickly investor confidence can evaporate, even in the absence of margin calls. The Shanghai Composite fell more than 70 percent in the 10 months ended Nov. 4, 2008, after jumping more than 400 percent in the previous two years.

    Leveraged investors have made so much money from rising stock prices that it would take a “big market slump” for them to start unwinding positions, said Yuliang Chang, the Hong Kong-based head of Chinese equities at Deutsche Bank AG.

    “There are ample buffers given how much A shares have rallied,” Chang said. (SD-Agencies)