July 10 – The Shanghai Composite and the Keynesian beauty contest

CHINA FINANCIAL - In Brief 10 Jul 2015 by Michael Pettis

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For months I have been arguing that the most worrying source of volatility in the Chinese stock market was not its speculative nature nor even the unprecedented use of margin. It was the large share of Chinese investors whose strategy was to ride what they believed to be a bubble. This to me is why the fall was so terrifyingly swift and so hard to contain. Why? Because a well functioning market requires a wide range of investment strategies and, even among investors with similar strategies, it requires information to be interpreted in a wide range of ways. If investment strategies converge, the impact of new information also converges. In China we saw a remarkable convergence in investment strategies and in the way information was interpreted. As Keynes explained with his beauty contest example, it is as if while players differed as much as ever on how they define beauty, they agree on how beauty is fashionably defined and know instantaneously of any change in fashion. The consequence is that they always select the same “winner”, and every change in fashion causes an immediate change in selection. This can only cause volatility to explode. It is too early to say, but the extent and ferocity of the market break and the panicked response of the regulators may result in even further convergence. If the rally is restored I have little doubt that the regulators will take steps to try to limit volatility. Margin, for example, will never be allowed to reach the extent that it had (and this has implications for credit growth, by the way), and a little sand might be thrown into the machinery, perhaps by raising transaction taxes or forcing wider bid-offer spreads. But we should...