By SHEN HONG
Updated Dec. 9, 2014 7:47 a.m. ET
SHANGHAI—Chinese stocks, the yuan and corporate bonds suffered their largest tumbles in years Tuesday after Beijing took fresh steps to rein in growing risks in the country’s debt-laden financial system.
The benchmark Shanghai Composite Index slumped 5.4% to record its biggest fall since 2009, after a regulator banned investors from using low-grade corporate debt as collateral to borrow cash.
The bond market was the first to fall, which sent yields higher, before the turmoil spread to the yuan, which recorded its biggest two-day tumble ever against the dollar.
The sudden moves serve as a reminder to global investors about the country’s risks, just as China has opened up stock investment to foreigners with the opening less than a month ago of a trading link with Hong Kong.
Adding to the gloom, policy makers gathering in Beijing this week for a summit are widely expected to lower China’s economic growth target for next year, after years of piling up debt to fuel rapid expansion.
The slump in the stock market was especially stark, although not entirely unexpected. A recent surge has made the Shanghai the world’s top-performing major index this year, fueled to a large extent by retail investors using borrowed cash to leverage their bets. That has contributed to the market’s wild swings in recent days and drawn warnings about the market’s stability.
“I was actually doing a presentation in my office during the last 10 minutes of trading, when my boss asked to me to stop and asked everyone to look at stock prices. Then I saw the incredible fall of the Shanghai index and my stocks that have turned from black to red in just a few hours,” said Wu Yunfeng, a Shanghai-based investor.
The broad selloff was triggered when China’s securities clearing house said late Monday it raised the threshold for corporate bonds qualifying as collateral for repurchase agreements, or repos, which are short-term loans with maturities spanning from overnight to 182 days. Bond investors such as insurers, mutual funds and brokerages use this as a prime channel of short-term funding.
“The new rule is to prevent risks from building up further as a result of high leverage in the market,” said Xu Hanfei, analyst at Guotai Jun’an. Mr. Xu also said that the combined outstanding value of repos on the country’s two exchanges has surpassed 700 billion yuan (US$113.5 billion).
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In its statement, the country’s securities clearing house said the new rule also applies to bonds issued by local-government financing vehicles. They have taken on huge amounts of debt in recent years to fund infrastructure projects around the country, but are struggling to repay debt as fiscal revenue has slowed in the face of sluggish growth and a downturn in the property market.
The move to cut down on using riskier forms of debt is central to Beijing’s structural reforms aimed at sustaining economic growth over the long term by reducing reliance on state investment and exports and increasing the role of consumption. That policy shift, though, could hold back expansion in the short term if it chokes off credit to industries such as steel and cement, where problems with overcapacity are widespread.
The selloff came on the same day that China’s Central Economic Work Conference, which meets annually to set the country’s economic priorities, convened in Beijing for discussions that will include setting the government’s economic growth target for next year. Most economists expect China will miss this year’s target of 7.5% and that the work conference will set a lower target for 2015. A lower target would suggest that Beijing is less likely to take steps to spur growth—such as interest-rate cuts or increased spending—that often spur market rallies.
China’s leaders have been striving to make the country’s stock market more attractive after years of lousy performance. Measures have included a crackdown on insider trading, limiting the number of new share offerings, and most recently opening the stock trading link between Shanghai and Hong Kong.
Still, the rapid pace of the recent run-up is likely something policy makers don’t like to see, especially given the leverage in the market. Even after the selloff, Shanghai remains up 35% this year, while the yuan is down 2.2% this year as the dollar has surged globally. Also, yields on China’s 10 year benchmark government bonds have risen 0.25 percentage point this month to touch 3.799% on Tuesday.
The selloff in the stock market was the top topic of conversation in the financial corners of microblogging service Weibo, as retail investors watched gains accumulated over a few days disappear in an afternoon.
“The Chinese stock market is sick,” said one post from the eastern Chinese city of Linyi.
“It earned a lot in the morning, and it dropped deeply in the afternoon,” said another post on Weibo. “I don’t know why this stuff dropped, and I don’t know why it goes up either. There’s almost no logic. It isn’t as good as going to the casinos in Macau.”
The Securities Times, a Shenzhen newspaper supervised by the People’s Daily, quoted an unnamed local securities official who said a meeting with financial institutions was convened, revealing the regulator’s concerns about margin trading.
According to the China Securities Finance Corp., a government agency that publishes data on margin loans, shares valued at 2.08 trillion yuan were being used as collateral to borrow from securities companies at the end of November, up nearly 2½ times from 843 billion yuan at the end of 2013. The volume accelerated in October, increasing by 324 billion yuan.
—William Kazer, Anjani Trivedi and Dinny McMahon contributed to this article.