In China, shares in listed companies are commonly used as collateral for obtaining loans. Total shares pledged have declined this year, amid stricter regulations. Nevertheless, given the recent sharp falls in Chinese equities, S&P Global Ratings believes the practice of pledging shares for funding could pose many challenges for Chinese companies. These include liquidity stress, losing control of key assets, and potential changes of ownership. All issues that raise the stakes for creditors.

In this report, we answer frequently asked question about the breadth of the practice, the types of corporate sectors most affected, and the credit implications in the case of further market fallout.

Frequently Asked Questions

How big is this issue?

It's a Chinese renminbi (RMB) 5 trillion (US$720 billion) issue. That's the market value of all shares pledged for stock-based borrowings in China at the end of September 2018. The value of shares pledged has expanded by more than RMB200 billion annually since 2014. In recent months we've seen a decline, partly due to a new regulation to control margin financing.

According to some industry estimates, more than 90% of listed companies in China have some degree of shares pledged as collateral, and about 20% of listed companies have more than 30% of their shares pledged.

Chart 1

Which companies or sectors are most exposed?

Capital-intensive sectors such as engineering and construction and real estate tend to be the most prolific in pledging shares for funding. About 20%-25% of the property and capital goods sectors' market capitalization has been pledged for borrowings. Sectors that have a high proportion of privately owned enterprises (POEs), such as technology services and retail, also show a high stock-pledge ratio. So do sectors with a high reliance on shadow banking channels, which indicates their weaker funding capabilities in traditional bank loans and debt capital markets.

POEs dominate borrowing against shares due to their weaker funding access and more aggressive practices in financial management. The RMB5 trillion market value of shares pledged is around 10% of total market value of the A-share index, however about 87% is borrowings by POEs. The share pledge ratio of state-owned enterprises (SOEs) for new margin financing has declined steadily in the past 10 years.

Chart 2

Who borrows the funds and why do they do this?

Owners of listed shares--corporations or large individual shareholders often pledge their shares to banks and other financial institutions to borrow funds. One of the key reasons is that many have large businesses outside of their listed companies. With the exception of buying new shares, share-pledged borrowings have no restrictions on use. Controlling shareholders may use the proceeds to finance new investments, refinance existing debt, or monetize their ownership without giving up control. In addition, stock-based borrowing is favorable because approval is relatively simple and funding cost is lower, given its collateralized nature.

Why is this a problem?

China's stock market has been falling in recent months. In common practice, the loan-to-value ratio of such borrowings is 50%, which means the collateralization level is 200%. Typically, when collateral level falls below 160%, borrowers need to top up their margin and may even face forced liquidation when collateral falls below a certain threshold.

This can create liquidity problems for owners because they need to find cash or other collateral to prevent liquidation. Cash-strapped owners may extract funding from listed companies through higher dividends payouts or other means, creating financial burdens on the listed entities themselves.

Share-pledged loans are usually short-term borrowings. In a falling price environment, lenders cut risk positions or are required by regulators to restrict these activities. Combined with the government's crackdown on shadow banking, finding funds to repay or refinance these loans could squeeze owners and listed companies alike.

In addition, if lenders start liquidating shares, equity prices may fall even further, creating a downward spiral affecting the listed companies' capital market standing, borrowing access, and customer confidence. It can also lead to potential changes of ownership in listed companies, affecting their management and strategy. In extreme situations, change of control could lead to accelerated debt repayment, although this type of creditor protection is not common in the onshore market.

Have there been cases of companies defaulting due to share-pledged borrowings?

Yes, we have also noticed that a high number of companies that defaulted in the onshore market this year borrowed against shares, in many cases pledging close to 100% of all owned shares of listed subsidiaries. This highlights that these borrowers are typically very aggressive in their expansions, or have weaker funding access to meet overextended balance sheets.

Companies may face a liquidity squeeze when their share prices plunge and creditors and investors quickly lose confidence in the company. For example, the Shenwu Group pledged 99% of its holdings on two listed subsidiaries, Shenwu Environmental Technology Co. Ltd. and Shenwu Energy Saving Co. Ltd. In January 2018, the failure to move forward with group restructuring to merge two listed companies and inject assets caused a share price plunge. This in turn led the lender, Huarong Securities, to unwind the borrowing when the Shenwu could not meet its buyback agreement with the lender. The company was ultimately unable to meet its obligation when bond investors demanded a redemption at the put date.

Are there any S&P Global Ratings rated companies that have these type of borrowings?

Yes. For example, Fujian Yango Group Co. Ltd. (B/Stable/--) and Elion Resources Group Co. Ltd. (B/Negative/--) have pledged a substantial majority of their shares in listed subsidiaries for borrowings. The owners of Xinjiang Guanghui Industry Investment (Group) Co. Ltd. (B/Watch Dev/--) and Oceanwide Holdings Co. Ltd. (CCC+/Negative/--) have also used the majority of its shares as loan collateral. These companies all have tight liquidity with high short-term debt maturing, as well as high financial leverage.

Is there any potential relief on the horizon?

Yes. The Chinese government and regulators are trying to stabilize the stock market and prevent widespread forced selling. In recent days, some local governments have taken steps to moderate share-pledge risks. The support measures to help meet margin calls on pledged shares including: bridge funding, entrusted loans, debt acquisition, and share acquisitions.

On Oct. 22, 2018, the Securities Association of China also announced a plan to raise RMB100 billion to provide liquidity support to companies facing margin-call pressure. In the first round, 11 security companies in China will each contribute RMB21 billion to the funding pool. Other investors such as banks, insurance companies, SOEs and private companies are also encouraged to participate.

However, so far, no specific details have been provided on how these support measures will be implemented, including: how the funding will be provided to the companies; the terms and conditions for the funding; how much the new investors will involved in the management and control of companies, if at all. In addition, it is likely that funding support will be focus on higher quality companies with sound business and financial fundamentals. Weaker companies are unlikely to directly benefit from these measures.

Therefore, in our view, these measures might not provide long-term relief unless there are fundamental improvements to the companies' internal cash flow generation and funding structure. Over the longer term, higher state ownership of listed companies (via purchases of distressed shares) may also hinder China's goal of improving corporate efficiency and deepen the market-driven dynamism of the economy.