Just when we thought there were no surprises left in the world’s foremost incubator of “financial engineering” that is China, we got a stark lesson in never underestimating China’s market manipulating ingenuity.
According to Caixin, around two dozen Chinese companies recently offered their employees a deal: buy company shares while guaranteeing that any losses would be covered. While employees think they may be getting an unbeatable deal – after all, who can say no when your employer promises you all the upside with no downside – the reality is that any participants in such scheme are merely locking in their fates with that of their soon to be insolvent employer who desperately needs to raise the price of their stock to fend off collateral calls on stock-backed loans
Still, as Reuters points out, attracted by guarantees that their principal is “safe” workers are eagerly stepping up to take advantage of the offers. However, it remains far from clear how these guarantees would work, with employees in some cases being asked to buy shares and hold them for at least 12 months. Details aside, many of the companies that resorted to this drastic stock price manipulation were quickly rewarded and saw their share prices spike.
The entire farcical episode is reminiscent of what happened in 2015 when China’s stock bubble grew exponentially, then burst just as dramatically. At the time, there were similar efforts, but then it was the government appealing to major shareholders’ patriotism to buy and hold shares in what Beijing said was as a battle against speculators, both domestic and foreign. This time, with the proposal centered entirely on the private sector, the motive is different and is the result of companies using their own stocks as loan collateral, a practice that according to Reuters’ estimates has quadrupled in China over the past two years, and which is driven mostly by founders and major shareholders posting large batches of stock as loan collateral in recent months.
Fundamentally a ponzi scheme, this works without a glitch during rising markets but falling prices especially among small and mid-cap companies, have eroded the value of that collateral, raising the specter of forced liquidation – where lenders, often Chinese brokerages, make borrowers sell the pledged shares. Selling the stock adds more pressures on share prices, triggering a downward spiral.
Shenzhen Fenda Technology, a maker of speakers and electronic accessories, was among the first to encourage staff to buy shares one week ago. At the end of March, Xiao Fen, the company’s chairman and top shareholder with a 44.5% stake, or 416.4 million shares, had put up 84% of his holding as collateral for a loan, the company said. It did not say what the loan was for. Trading in the company’s shares was suspended in late December pending a reorganization, but resumed in mid-April, when the stock price slumped to near their 2015 market crash low. Last Friday, Xiao promised any employee who bought shares in the company by June 6 and held them for at least a year would be shielded from losses.
What he did not say is that any employee who took advantage of the “generous offer” was effectively providing a bailout lifeline to the chairman. This probably should have been explained to the workers who participated in the offer simply because they saw their co-workers jump right in. “A lot of colleagues I know have bought shares. I have too,” said one worker, who gave only his family name, Li. “The company is quite good and the chairman has guaranteed principal, so, of course, we’re interested. I know some colleagues even bought shares with borrowed money.“
Shenzhen Fenda Technology shares jumped by a tenth after the announcement, but have since edged back down.
Also last Friday, Shenzhen-listed Hunan Kaimeite Gases launched such on offer with a four-day deal. Other companies offered similar deals but for different lengths of time. Kaimeite justified the ludicrous proposal by saying its stock was – what else – “undervalued”: “The company is undervalued due to recent volatile trading of the market,” according to Kaimeite Gases’ announcement, filed with the Shenzhen Stock Exchange on Friday. “The buyback plan is to boost investors’ confidence, and it’s based on our bullish view on company’s outlook.”
Immediately after the buyback proposal, shares surged: Kaimeite Gases jumped by the legal daily maximum of 10% to 8.86 yuan ($1.30) last Friday. It closed at 8.98 yuan on Tuesday — the day the employee deal ended. As of May 31, the prices of shares of Kaimeite dropped 26.1% since this year’s peak of 10.94 yuan on Jan. 25.
Many others quickly piggybacked on the idea.
The price of Guangdong Biolight Meditech stock fell by a quarter this year, undercutting the value of the 14.6 million shares that its chairman Yan Jinyuan posted as collateral as of the end of the first quarter. On Monday, Yan made a promise like Fenda’s Xiao, and the share price also rose.
With the idea spreading fast, about 100 notices on share buybacks were filed by companies’ major shareholders to A-share markets from June 1 to Tuesday, according to financial data provider Wind Info. By comparison, the number of notices on reducing shares stood at 26 during the same period.
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In a sign that at least someone in China is paying attention, some analysts criticized the practice as a “bailout style” buyback for struggling companies. Xu Yang, chief analyst from HuaAn Securities Co., said it is hard to argue that paying for losses is a smart move for the market over the long term. “Buyback from major shareholders usually provide support on sentiment during market downturns,” Xu said. “But this kind of buyback notice could lead to potential risks of market manipulation.”
Wu Kan, head of equity trading at Shanshan Finance, said that however well intentioned these efforts are, usually by the companies’ founders or big shareholders, there is a question mark over their financial ability to make such guarantees. “It could be driven by the genuine belief that the stocks are worth investing in. But it could be a desperate move to prop up share prices to avoid margin calls,” he said.
Furthermore, the promise to take any losses “isn’t legally binding and largely depends on big shareholders’ virtue. And you can’t rule out insider trading during the process, which is why regulators are demanding better disclosure,‘ he added.
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Growing concerns about the lunacy of this latest ponzi scheme to manipulate stocks higher have failed to prevent gullible employees from rushing in. Sun Xishan, a sales worker at Biolight, said he missed the chance to buy stock on the day of the announcement, but would try to get in on the shares later. “I know the company well, it’s in pretty good shape and its performance is growing. The chairman promised to cover losses if any, so it’s hard not to be interested if one has money,” Sun said, cited by Reuters, who is about to lose all the money he puts into this “guaranteed” profit scheme.
The scheme however unveils a deeper threat facing China’s smaller publicly-traded companies. If markets continue to slide, there could be a surge in margin calls on these loans, potentially triggering a vicious cycle of share selling, increasing the risk of broader financial instability. “If stock prices fall, but shareholders don’t have enough capital to replenish their collateral, the pledged shares would face forced selling,” said Meng Shen, director of Chanson & Co, a Beijing-based boutique investment bank. “That would develop into a negative spiral; as the more you sell, the lower the stock price, which would then trigger more forced selling.”
Of course, China has a broader issue with collateral that could endanger the health of its financial system – as discussed last week, fraudulent or “ghost” collateral, where pledged products either don’t exist or are already sold or pledged to multiple lenders.
BofA strategist David Cui warned that a potential “vicious selling circle” could lead to a replay of China’s mid-2015 market crash. “As the 2015 experience shows, with high leverage, a vicious selling circle can quickly develop,” he said, noting a “moderate” risk of broad-based financial instability. At that point either Beijing will have to step in with another bailout, or scenes such as this one which emerged during the 2015 market rout, will become the norm once again.