Shanghai, Hong Kong shares fall as China launches new probe into margin trading

By Kazunori Takada and Sue-Lin Wong

SHANGHAI (Reuters) - China's stock regulator has launched a fresh probe into brokerages which are lending money to investors to speculate on stocks, amid concerns that the country's share markets are becoming over-leveraged and vulnerable to a crash which could strain the banking system.

The regulator will inspect the stock margin trading business of 46 companies, the official Xinhua news agency said.

Sources had told Reuters on Wednesday that regulators were renewing their investigations into margin trading, which hit record highs this week as more investors pile into the sizzling rally.

In addition, banks have been ordered to tighten lending supervision to avoid loans being funnelled into stock markets. Chinese banks' bad debt ratios are already at five-year highs and a sudden correction in the stock market could exposure them to significant additional risks.

"The inspection belongs to normal regular supervision and should not be over-interpreted," Xinhua said late on Wednesday, quoting the China Securities Regulatory Commission (CSRC).

China stocks fell as much as 2 percent at one point in morning trade, but the drop was relatively mild compared to the near 8 percent plunge they suffered on Jan.19 after the CSRC punished three top brokerages for illegal conduct in their margin trading business.

By midday, the CSI300 index of top Chinese companies was down 1.0 percent at 3,490.7 points while the Shanghai Composite Index (.SSEC) was down 1.2 percent at 3,267.8 points.

“The news of resuming investigation into stock margin trading will only bring limited impact to the market," said Liu Jingde, analyst at Cinda Securities in Beijing.

"The fundamentals have not changed. Brokerages are about to report earnings and most of them had very good performances last year."

The Hong Kong market tracked the mainland lower, with the Hang Seng index (.HSI) dropping 1.2 percent to 24,569.2 and the China Enterprises Index (.HSCE) losing 2.3 percent.

After the mid-January crackdown, regulators followed up by reassuring the market that they were not trying to suppress the rally, which has been one of the few bright spots in Chinese capital markets, but seeking to manage risks.

Still, market watchers such as credit agency Moody's said the earlier penalties illustrate widespread weaknesses in the brokerages' risk management processes and internal controls.

"As we should assume that brokers have borrowed money from other financial institutions to lend on margin, systemic risk is certainly rising," said Oliver Barron, head of China research at NSBO in Beijing.

"If the market were to move sharply lower, some smaller brokers could easily default on obligations to other financial institutions. But just as happened in 2014 when large amounts of trust products were coming due, the central bank will likely step in and provide liquidity before any major problems emerge."

Chinese stocks have surged by around 40 percent since November, raising some concern that the rally is out of step with a marked slowdown in the world's second-largest economy which is depressing sales and profits.

The tide of money into stocks -- much of it borrowed -- follows a recent cut in interest rates and a weak property market, which is traditionally a strong investment destination for household savings.

The outstanding value of margin loans used to purchase shares has hit record highs for the past three days, reaching 780 billion yuan ($124.5 billion) on Wednesday.

The CSRC punished three of the nation's largest brokerages this month for illegal conduct in their margin trading businesses. At the same time, banking regulators moved to curb abuse of short-term forms of credit in the interbank market that were seen as being used for stock market speculation.

(Additional reporting by Samuel Shen and Shanghai newsroom; Editing by Mark Bendeich & Kim Coghill)