China breaks the rules on bank loans for stock investment

Should China's financial system follow the lead of America's collapsed Silicon Valley Bank?

China recently reversed the long-standing rule that commercial banks in the country are banned from making loans for investment in the stock market.

The move has triggered speculation that Chinese regulators are now channelling credit from the banking system into the stock market, in order to keep share prices afloat as China's economy potentially comes under pressure.

One leading analyst argues, however, that China is still determined to keep a lid on speculative investment in stocks, and is instead making pivotal adjustments to the financial system to fund decoupling of the tech sector from the US.

China has long banned bank loans for stock purchases

In China, the government strictly applies the rule that "funds from loans cannot enter the stock market" (信贷资金不得流入股市).

Consequently, it's long been general consensus amongst Chinese investors that bank loans "cannot be used to invest in stocks or equity, but can only be used for productive operations."

A slew of rules and regulations prohibit borrowers from banks using their funds to buy shares.

Chief amongst them are the "General Regulations on Lending" (贷款通则).

The Regulations state that "loans cannot be used to engage in equity investment unless the government rules otherwise," and that they "cannot be used to engage in speculation in securities or futures."

The "Administrative Measures on Liquidity Loans" (流动性贷款管理办法) also state that "working capital loans cannot be used to invest in financial assets, fixed assets or equity."

PBOC has just changed the rules

The People’s Bank of China (PBOC) - which is the Chinese central bank, recently made the groundbreaking decision to allow banks to make loans for the purpose of share purchases.

The move arrives as China's economy continues to struggle with lacklustre growth and disappointing domestic demand, and the government steps up its focus on maintaining the health of the stock and property markets.

In October of this year, PBOC announced that it would encourage financial institutions to provide loans to listed companies and their key shareholders, to either support share buybacks or increase their equity stakes in these companies.

The central bank hopes to achieve this via the creation of the Share Buy Back and Increase Re-loan (股票回购增持再贷款), along with a pilot scheme involving the participation of 21 of China's nationwide financial institutions.

On 3 December, Chinese media also reported Shanghai would conduct a city-wide trial for banks to provide loans to the employees of tech companies, in order to participate in their share incentive plans of these firms.

Individuals will be permitted to borrow up to 20 million yuan, while for enterprises the credit threshold is set at 100 million.

China wants to finance tech decoupling

Some commentators have claimed that Chinese regulators have made the imprudent decision to prop up a skittish stock market, via the use of funds sourced from the banking system to provide credit to speculative investors.

Wang Jian (王剑), chief financial sector analyst at Guosen Securities, argues that this is not the case at all, and that funds will be barred from entering the hands of investors for speculative purposes.

The changes are instead part of efforts to channel more funds to Chinese tech companies, as Beijing seeks to decouple from the US tech sector amidst worsening trade tensions.

Wang sees China giving greater play to the stock market in a financial system long dominated by state-owned banks, in order to better channel funds to innovative tech companies.

As part of these changes, banks will instead play a vital support role when it comes to the financing of the tech sector, necessitating adjustments to the permitted use of the loans they extend.

"Different financial tools have their advantages and disadvantages, and an even stronger capital market cannot satisfy all financing needs," Wang writes.

"Even in a financial system where the capital market plays the main role, bank loans can play a positive, or even necessary, role of supplementation."

Why China should draw inspiration from collapsed Silicon Valley Bank

Wang surprisingly points to Silicon Valley Bank (SVB) - the San Francisco-based lender that collapsed in March 2023 following a bank run - as a healthy example of how loans from depository institutions can complement the role of the capital market.

"SVB is a classic example of servicing tech ventures," he writes.

Wang points out that many of SVB's clients were start-up tech ventures that used loans from the bank to tide them over in between different funding rounds.

"A large share of loans were not paid back from the future operating cash flows of clients, but from future fund-raising rounds," Wang writes.

"These types of bridge loans can enable investors and businesses to operate with greater ease, without needing to worry about dealing about temporary tightness in liquidity.

"For this reason, even if the capital market is the main force in supporting the financing of tech ventures, banks are still an extremely necessary supplement.”

Wang further points out that another one of SVB's key operations was lending to venture capital funds, which is "in principle the same" as lending to tide over enterprises between funding rounds.

"Investors participate in venture capital funds in rounds, and once one round concludes, the venture capital fund commences its investment in enterprises,” he writes.

"If venture capital funds suddenly face an urgent capital need (due to one of the enterprises meeting with a contingency) before the next round of funds arrives, then banks can provide credit, and repayment can be made after the next round of investors provide capital."