Are Credit Expansions to Blame for Stock Market Exuberance?

The study, titled Effects of Credit Expansions on Stock Market Booms and Busts, was conducted in collaboration with Prof. Christopher Hansman at Imperial College London, Prof. Harrison Hong at Columbia University, as well as Prof. Liu Yu-Jane and Prof. Meng Juanjuan at Peking University. It found support that expansions in the supply of credit, at least in China’s example in the 2010s’, can lead to a sizable increase in equity price levels, and that this is something that tends to be largely anticipated and priced in by investors ahead of time.

Margin Trading in China

Margin lending refers to the practice of using borrowed money to purchase securities in the stock market for investment. The practice, while prevalent in most developed markets in the world, is considered inherently risky because it magnifies investor losses, especially when markets are volatile. In China, trading stocks on margin was not allowed until 2010, when a pilot programme was launched on the country’s Shanghai and Shenzhen bourses on a limited number of stocks, and subsequently expanded in phases.

At the time, it was widely believed that the introduction of margin trading would help to increase stock transaction volumes and inject vitality into the market. However, because the scheme was paired with an expansion of lending to brokerages, it led to a skyrocketing in margin debt, which rose from 403 billion Chinese yuan in Jun 2014 to more than 2 trillion yuan, or around 4.5 percent of total market capitalisation, by the same time a year later. Share prices surged, with the Shanghai Composite index more than doubling from the 2,000-point level in the middle of 2014, to 5,166 in June 2015, before crashing back down to around 3,700 points in the space of three weeks after the government implemented a series of measures to cool overheated markets.

“This episode, which we now come to know as the Chinese stock market crash of 2015, provided us with an ideal setting to study the effect of credit expansion on prices in asset markets and their relationship to the cycles of economic boom and bust that economies around the world experience,” says Prof. Jiang, adding that not only was the expansion of lending during the period narrowly focused on the stock market, but the phased nature of the government’s plan to slowly allow investors to trade an increasing number of companies on margin also affords the researchers a detailed look at how specific events affected the market.

Investor Anticipation

To go about their study, the researchers matched stock prices, trading volumes and other financial data of companies on the two Chinese exchanges, with their level of outstanding margin debt for the period between March 2009 and May 2015. To measure participation by institutional investors, they also compiled information from Chinese regulatory filings by public companies and mutual funds in China.

“Our research underscores the importance of market expectations of credit expansions.”

Prof. Griffin Jiang Wenxi

The researchers found that in the months leading up to the launch of margin trading in China and during its phased implementation, there was a consistent increase in the price of stocks that were expected to become eligible for the programme at the upcoming stage, with substantial purchasing being made by relatively liquid institutional investors and mutual funds. On the other hand, there was little change in the price of stocks after they officially became available for margin trading.

“In other words, investors appeared to have pre-empted the expansion of margin debt by Chinese regulators, exactly as theory would predict in a world where changes in credit are not entirely unexpected,” says Prof. Jiang, adding that the rise in stock prices tended to be gradual rather than sharp, as expected in a situation where investors were acting not on a single regulatory announcement, but were gradually resolving the uncertainty surrounding the extent of how margin trading would be implemented in China as well as which companies were to be included next.

Next, the researchers sought to isolate increases in stock prices from investor anticipation of which companies would be included in the next phase of the expansion. By comparing companies that barely qualified for margin lending against those that just failed to qualify, they found that stocks which were just above this threshold indeed saw a sharp influx in margin trading in the year following its inclusion, and this was followed by a subsequent and non-trivial increase in its stock price. They found that companies that just made the criteria to be included in margin trading experienced around a 20 percent increase in its 12-month cumulative returns, compared to those that just failed to qualify.

Prof. Jiang and his collaborators then constructed a theoretical model to understand and extend their understanding of this behaviour to a more general population of stocks. The results supported earlier findings that the inclusion of a stock for margin lending led to around a 20 percent increase in returns. It also suggested that investors anticipated the impact of margin lending as information gradually become available, and this meant that as much as 60 percent of the direct effect of margin trading would became incorporated in a company’s stock price as early as six months ahead of its debut in the programme.

Modelling the 2015 Market Collapse

Finally, using this model, the researchers constructed a set of hypothetical scenarios surrounding the timing of the Chinese regulatory intervention in 2015. Facing soaring stock prices, the country’s securities watchdog, the China Securities Regulatory Commission, in June 2015 released new rules that put a cap on the volume of margin trading business that brokerages were allowed to do, while reiterating its intent to crackdown on “shadow” margin trading done outside approved channels.

In the first scenario, Prof. Jiang and his co-authors looked at that what would happen if regulators had intervened in the market earlier in September 2014, when the third round of expansion in the country’s margin lending programme occurred and more companies became eligible for margin trading by investors. Their model indicated that at that point in time, investors had already priced in the stock prices of companies expected to be eligible for the next round of expansion, by 45 percent. However, by June 2015, when the actual intervention occurred, that figure rose to 82 percent.

Given the total market capitalisation of the firms that would have been included in the next round of the expansion in margin lending in China came in at around 1.22 trillion yuan at that time, this suggests that if regulators had acted in late 2014, they could have avoided the market from rising further to the tune of around 70 billion yuan. In another scenario, they modelled that if regulators had not intervened in June 2015 and allowed the next phase to go ahead, then the value of the companies in that round would have risen by a further 40 billion yuan.

The researchers say the results suggest that more timely regulatory action may have helped to prevent a significant anticipatory price increase in the set of stocks expected to next qualify for margin lending. “Our research underscores the importance of market expectations of credit expansions and shows that accounting for investor anticipation can be crucial for the design and implementation of prudent policy,” says Prof. Jiang.