Rational Panics, Absorbing Regime Switching And Stock Market Crashes: Empirical Evidence From The State-Share Paradox1

A government policy regarding the reduction of state shares in state-owned enterprises (SOE) triggered a crash in the Chinese stock market. The sustained depression even after policy adjustments constitutes a puzzle— the so called “state-share paradox.”The empirical evidence shows that the sustained depression is supported by a regime switching model with an absorbing state. The theoretical explanation developed in this paper arises from the concept of rational panics, which generates an inverted-S actual demand curve and gives rise to potential multiple equilibria. Rational panics hypothesis in this paper suggests that the dual pricing system and the quota on the overall stock supply represent major policy failures.