A series of monetary easing moves and capital market reforms led to a surge in mainland shares since late last year. However, this was also driven by huge borrowing on margin to buy stocks.
As a result, as China's markets slide, there is a risk of financial contagion through the unwinding of massive leveraged positions, according to Aidan Yao, senior emerging market economist at Axa Investment Managers.
Of the total RMB3.3trn ($500bn) in leverage, a significant portion is from banks, brokers insurers and shadow banking entities. These financial houses have raised money from instruments like wealth management products and channeled it into a margin financing business, said Yao.
“Some of these institutions also use their own capital and money issued from the bond market to finance the equity-lending business. Further free-fall of the equity market could inflect severe pain on these leverage providers, causing a wide-spread contagion in the financial system,” said Yao.
This could lead banks and financial institutions to cut back on lending due to an increase in bad loans, Yao added.
"Of the total RMB3.3trn ($500bn) in leverage, a significant portion is from banks, brokers, insurers and shadow banking entities, which have raised money from wealth management products and channeled it into a margin financing business"
Craig Botham, emerging markets economist at Schroders said there was a notable surge in the contribution of the financial sector to the country’s GDP in the first quarter.
“This reflects a boom in brokerage businesses, which is unlikely to be sustained in light of current market conditions. This will likely weigh on growth in the third quarter, particularly if efforts to shore up the markets are unsuccessful,” said Botham.
A continuing stock market decline will make it difficult to achieve the 7% annual GDP growth target for this year.
“A final question is whether a stockmarket crash could trigger a hard landing more generally.
“There is an argument to be made that it would undermine faith in the assumed omnipotence of the government in handling the economy, with a potential focus being the rest of the financial system,” Botham added.