SHANGHAI, June 4 (Reuters) - As Shanghai's main stock index plunged another 8 percent on Monday, fears grew that policymakers misjudged last week's bid to cool the market, but analysts say there's still enough cushioning for a soft landing.
The Shanghai index has lost 15 percent since Wednesday, when the government raised the share trading tax. The aim was not to burst the speculative stock bubble but to trigger a gentle deflation, avoiding an extended bear market that could drive investors away for the long term, damage the economy and even prompt social unrest.
In an apparent effort to calm investors, China's three major state-owned business newspapers ran front-page editorials on Monday declaring that the tax hike would not change the market's positive medium- and long-term outlook.
So Monday's plunge, the second-biggest drop this decade, raised concern that the situation might have spiralled beyond the authorities' ability to control it.
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"The Chinese government is just trying to rein in speculation and stop the market from going up too quickly. They did not expect the reaction to the tax would be so big," said Xia Xiaohui, chief executive of private investment fund Fair Capital.
Some fund managers said another tumble of 5 percent or more on Tuesday could send the market into a freefall, as even institutional investors, which focus on longer-term investment, might start selling heavily to cut losses.
Millions of individuals have entered the market in recent months to join a bull run that took the index up 273 percent between the start of 2006 and last week's record high of 4,335.963.
The problem is not that these investors disbelieve the government's assurance about the market's longer-term uptrend, it's that they might not want to wait around for the longer term if the short-term trend is no longer up, analysts said.
"Most new retail investors are too speculative to envision the 'mid- to long-term positive market trend'. Their exit will cause a market landing, be it hard or soft," Jerry Lou, analyst at Morgan Stanley, said in a report.
Valuations suggest the market has room to fall further if investors continue pulling out. After Monday's fall, the Shanghai market was priced at about 31 times this year's corporate earnings, assuming earnings growth of 30 percent. That's still around twice the valuations of many overseas markets.
However, many analysts and fund managers said that while it was unclear exactly when shares would bottom, they expected the index would stabilise before the drop began to have serious long-term implications for the market or the economy.
Many believe that since the newspaper editorials have failed, the government will take stronger steps to restore confidence.
"New measures could be introduced in the next few days or weeks to boost near-term market sentiment and to avoid a market hard-landing on retail investors' panic selling," Lou said.
One way to support the market would be to guide institutional fund flows. There were signs on Monday that authorities had started to do this; sources close to the securities regulator told Reuters it had approved four new equities investment funds.
In addition, authorities could begin approving new foreign fund flows into the stock market, after China said last month it planned to lift the ceiling for foreign investment to $30 billion from $10 billion.
Officials could also publicly deny policy rumours that have worried the market, including talk that a stock capital gains tax may be imposed. A probe of illicit lending to stock market investors might be watered down, while the central bank could, if necessary, slow its monetary tightening campaign.
Although selling of stocks has snowballed in the past several days, analysts believe most of the retail money flowing into stocks has been moved straight from bank savings deposits, and was not borrowed. That means the market fall may not add much to household or corporate debt.
"While equity market leverage is growing, it has not even come close to reaching a point where a correction leads to significant balance sheet stress," UBS said in a report late last month.
And even a 30 percent drop from the Shanghai index's all-time high — a normal pull-back for a market in the context of an uptrend — would still leave it more than 10 percent higher than it was at the start of this year.
That would leave many institutions still sitting on large profits from the bull run, giving them plenty of capacity to buy into any rebound.
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