China trials short selling

As western countries vilify the practice of short selling, China agrees to allow more complex trading strategies.
The China Securities Regulatory Commission (CSRC) is to allow margin trading and short selling of A-shares on a trial basis. To begin with, only a small number of brokerages will be able to participate and it will only be possible to short a designated set of stocks. Although there is no firm timetable for when the measures will come into effect, people working in asset management believe it could be as soon as November.

The trial is part of a series of measures that the Chinese government has recently introduced in an attempt to revive the ailing A-share market û the China Securities Index 300 is down 60% year-to-date. Last month, in the same vein, the government cut interest rates and removed stamp duty on buying shares.

Ironically, China is making this move as short selling in the US and Europe has been singled out as one of the bogeymen responsible for the current financial crisis. Both Britain and the US have temporarily banned short selling of financial stocks.

"Margin trading could add more liquidity into the system [in China]," says Gabriel Gondard, deputy chief investment officer at Fortune SGAM Fund Management. ôThere is the idea that short selling could add additional volatility, but it is likely that we are at the bottom of the market, so it is unlikely that it could do much harm.ö

Margin trading refers to the practice of brokers lending money to their clients so that they can buy shares - thus increasing the amount of capital available for stock market investments. One research report noted that the introduction of margin trading in Taiwan in 1990 resulted in a significant increase in trading volumes. However, the higher leverage also increases the level of risk.

Hitherto Chinese investors have not been able to employ the full range of trading strategies as their counterparts in more developed markets. "When stock prices were significantly higher in both price and P/E terms, those with a negative view were left with a limited palette of options. All you could do was sell out and then sit on your hands until prices got lower," says Michael Kurtz, Macquarie's head of China research.

Without a specific timetable and any details to how broadly the measures will be applied, it is difficult to see how much capital will be used, and therefore quantify the potential impact. But the initial introduction to select brokers, based on their net capital and risk management capabilities, suggests that the new products might not be a mass-market offering in its early stages.

There are some specific details available: securities firms will only be able to use their own shares and capital, and the CSRC says in its statement that, to begin with, there will be more margin trading than short selling because the securities companies have more cash than shares that they can lend. (When you sell short, you have to borrow the same amount of shares from someone else in order to settle the trade.)

The margin requirement has been set at 50% of the share's purchase price, or at 50% of the proceeds of the short sale. The minimum maintenance margin will be 30% of the value of the shares traded.
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