China's crackdown on short selling may not have as much impact as officials hope

The slow-motion collapse of Evergrande, the world’s most indebted company, entered what is likely to be its final stage on Monday when a Hong Kong court ordered its liquidation.

The property developer, which has more than $300bn worth of liabilities, has been approaching this point ever since, in December 2021, it first missed a bond payment and was declared to be in default.

Since then, various attempts at a restructuring have been made, none of which have even come close to passing muster with Evergrande’s creditors.

So today was the day the authorities finally lost patience.

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Under the court’s ruling, creditors will now be able to assume control of Evergrande’s parent company and liquidate its assets, freeing up cash to repay its debts.

That’s the theory, at any rate. In practice, a lot of Evergrande’s assets have already been sold, frozen by the courts or seized by creditors. It is far from clear what is left for creditors.

What is also unclear is how far the Hong Kong liquidator’s remit runs in mainland China.

While Evergrande was listed in Hong Kong, its assets were in China, raising questions about how much foreign creditors in particular will be able to recover.

Evergrande has already told Chinese media that its priority will be to complete housing projects it already has underway.

Given the ongoing uncertainty caused by this situation, and the potential knock-on effects for other indebted Chinese developers negotiating with foreign creditors, one might have expected there to be a more dramatic response from stock markets in the country, particularly as some sector watchers warned several years ago – others did not – that Evergrande’s collapse could be a ‘Lehmans moment’ for China’s indebted property sector.

Yet, in the event, the Shanghai Composite, the main Chinese stock index, fell by just 0.92%.

That partly reflects that the liquidation of Evergrande was an event that had already been largely priced in by the market.

It probably also reflects that Evergrande’s liquidation does not necessarily mean the liquidation of other debt-laden Chinese property groups.

And, to an extent, it may also reflect an action taken by the Chinese authorities at the weekend.

Attempt to shore up confidence

The China Securities Regulatory Commission banned the lending of so-called restricted shares, those securities offered to investors or employees by a company with limits on their sale period.

It has also announced more curbs on the refinancing of securities – the practice of a shareholder lending their shares in listed companies to a borrower via an exchange.

There was no guidance on how long the measures would remain in place.

Both are aimed at reducing short selling – the strategy by which investors seek to profit from selling a security they do not own with the anticipation of buying it back later after its price has fallen.

Stock lending is central to the strategy because the short-seller acquires the security to sell by borrowing it.

The measures are Beijing’s attempt to shore up confidence in stock markets after many months of declines. The CSI 300 – the index comprised of mainland China’s biggest 300 listed companies – has lost a third of its value since 2020 having fallen in each of the last three years.

The more broadly-based Shanghai Composite, similarly, is down 17% in the last three years and has fallen by 12% during the last year alone. That has driven away many retail investors – some of whom have incurred heavy losses by investing in derivative products known as ‘snowballs’ – and foreign investors alike.

The Financial Times recently reported that, since peaking at $33bn in August last year, net foreign investment in China-listed shares fell by 87%.

The move recalls attempts made by regulators elsewhere around the world to try and maintain orderly markets (in other words, stop sharp falls) during the financial crisis.

For example, in June 2008, the old Financial Services Authority introduced a new rule under which investors had to disclose any net short position of more than 0.25% in the equity of a company bringing a rights issue.

In September that year, it went further still, introducing an outright ban on the short-selling of financial stocks.

Unpopular restrictions

It was followed shortly afterwards by the Securities and Exchange Commission, the main US securities regulator, introducing a similar ban.

Similar measures were implemented across a number of EU countries during the pandemic-induced stock market turmoil of 2020.

Bans on short selling, or restrictions on stock lending, are unpopular with market professionals.

They argue that, not only do short sellers add liquidity (the ease with which a security can be bought or sold) to markets, they also aid the “price discovery” process, whereby buyers and sellers come together to establish the correct price for a security at any given moment.

That opposition is justified. Research by Cass (now Bayes) Business School suggests short-selling bans hurt liquidity and price discovery while doing little to support stock market valuations.

That was supported by research by the European Securities & Markets Authority (ESMA) into the 2020 short-selling bans in Europe.

It found that, while liquidity and the price discovery were hurt, there was no evidence that the bans supported the prices of the shares in question.

That is likely to be the experience in China now.

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It is worth noting that stock lending and borrowing was not particularly common in China to begin with.

The Beijing Stock Exchange, which specialises in small and medium sized companies, only permitted stock lending and borrowing in February last year.

And, while permitted on the larger Shanghai and Shenzen stock exchanges, the practice was restricted to exchange members.

So this measure, while attracting headlines, may not have as much impact as the authorities hope. It appears to be a largely cosmetic exercise aimed at shoring up confidence among retail investors.

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