The Chinese stock market continued to bounce around today, driven down largely by the poor performance of bank stocks.  There were fears among investors that we may see more tightening measures in the form of hikes in interest rates or minimum reserve requirements, or both, and these fears have hurt bank stocks in particular.  Shanghai opened the day down about 1% and quickly dropped another 1% or so in the first few minutes, before trading up in the late morning and bouncing in and out of positive territory all day, until by late afternoon it was up 0.6%.  In the last 30 minutes, however, it gave up all its gains and then some to close down 0.73%.  That doesn’t bode well for tomorrow, but either way I don’t think there was a lot of conviction.

A couple of my Peking University students who trade regularly and who keep track of the market gossip tell me that there is a real sense among investors that the government is in control of the market and won’t allow it to fall much further – 3000 seems to be the magic number below which it can’t fall (the SSE Composite closed at 3681 today).  This has buoyed market sentiment and has kept investors in the market.  Needless to say, this kind of belief can cause damage to the capital allocation mechanism by distorting the market clearing mechanism. 

There is something else here that may be of interest to those curious about the mechanics of the markets – and the rest of this post is not really about the Chinese financial markets.  It is just some speculation on ways in which markets can adjust after distortions have been introduced, so probably of very little interest to most of the regular readers of this blog.

It is widely known that the perception of a minimum trading level, enforced by some credible agency, can distort the actual trading level in a predictable way – keeping it above whatever the fundamental level supply and demand would have naturally created.  I try to show this in the graph below:

In the graph, assume that the hard horizontal line is the perceived minimum trading level of the SSE Composite permitted by the government (which the market perhaps assumes to be around 3000 or just below).  If we assume that normal supply and demand in the market would have caused the index, absent government support, to move up and down the upward sloping straight line labeled “fundamental value”, the implicit belief in the government support level will actually drive the market along the curved “trading value” line, so that its price will lie directly above where it should have traded without the perception of government intervention.