Margin is one of the main culprits in the current Chinese stock market rout: the use of margin, the abuse of margin and the restriction of margin.

Margin is a loan from the broker to the client, allowing the client to buy 100 yuan worth of stock with typically only about 20 yuan down.  In this example, it gives the market five times the liquidity of the client’s actual investment.

The government encouraged margin lending to an unsophisticated class of retail investors. Their subsequent use of margin fueled a large part of the rally that sent the Shanghai Stock Exchange Composite Index up 152% to 5166 in the 12 months ended June 12.

On June 18 the amount of margin on the A-share market was a record 2.27 trillion yuan, according to Caixin. This was the same week the government tightened the margin rules to reduce that leverage.

In a clear case of be careful what you ask for, the government got what it wanted. People began reducing their leverage. This sparked a 30% plunge in the Shanghai Composite.

“The amount of margin trading involving securities firms fell by a record 170 billion yuan on July 8,” reported Caixin. “This was the 13th straight day the figure declined, lowering the amount of borrowed money in play to 1.46 trillion yuan.”

That’s a 36% decline in the amount of margin in the market over three weeks, compared to a 30% decline in the market’s total value. Those numbers are pretty close. Roughly speaking, they both fell about a third. Anyone see a connection?

The big problem with margin trading is that when the stock’s price falls to a point where it can no longer serve as collateral for the loan, the client needs to come up with more collateral. Typically, the client just sells the stock to pay off the loan. The big fear is hundreds of thousands of investors selling their stock at the same time to pay off their loans. This will trigger an even bigger selloff.

So far that hasn’t happened. Caixin reported that over the past month, hundreds of thousands of investors using borrowed funds sold their stocks mostly to lock in profits. They feared the stock market rout would continue, employees of securities firms said. Only a small amount were done because of margin trading rules that require sales when share prices fall to a certain level.

If the Shanghai Composite Index falls to around 3,000 points, forced sales will likely occur on a big scale, an employee of a brokerage in the capital told Caixin. The index fell to 3,373 Thursday, but closed up 5.8% at 3,709. On Friday, the index jumped another 4.5% to 3,878.

The point we made Monday still holds. Chinese stocks are held by weak hands, retail investors so unsophisticated they don’t fully understand how a stock market works. Of course, they will sell at the first sign of trouble.

The government needs to implement the reforms needed to get share into strong hands, people with a longer-term perspective. We’re talking about institutions. Currently institutions hold very little equity.

The government has made the right moves by allowing greater participation of Chinese pension funds and insurance companies. Now they need to step up and do their part.

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