THE world's top-performing markets of Shanghai and Shenzhen are looking shaky as over-leveraged investors pull back amid tighter lending rules.
The sell-off intensified after investment bank Morgan Stanley yesterday warned clients that "this is probably not a dip to buy".
Both markets hit year-highs on June 12, but it has been downhill since then, largely in part to government rule changes.
Tighter regulations on margin-financing have hammered leveraged trading, where borrowed money is used to buy shares.
Margin loans on the Shanghai Stock Exchange dropped for a fourth day on Thursday.
The increasingly sour mood sent Shanghai dropping 7.4 per cent yesterday, while Shenzhen fell 7.87 per cent.
The Hang Seng China Enterprises Index of mainland companies in Hong Kong fell 1.78 per cent and the Hang Seng Index skidded 2.82 per cent.
The Shanghai Composite Index has now plunged 18.8 per cent since June 12, while the Shenzhen Composite Index is down 20 per cent, putting both technically on the verge of bear territory. This is defined as share prices falling more than 20 per cent from their previous peak.
Concern over dwindling liquidity helped fuel the losses this week as investor funds got diverted to new initial public offerings and the People's Bank of China refrained from easing monetary policy. This disappointed investors who had anticipated a cut in interest rates or in banks' reserve requirement ratios.
But even with the latest sell-off, Shanghai is still up 106 per cent since June 27 last year.
Analysts are split over whether China's longest bull market has peaked or if it is a transition to a slower pace of growth.
Mr Jonathan Garner, head of Asia and emerging-market strategy at Morgan Stanley in Hong Kong, said in yesterday's report: "We think the balance of probabilities is that the top for the cycle on Shanghai, Shenzhen and the ChiNext has now taken place."
He cited the increased equity supply, weak earnings growth and high valuations.
Morgan Stanley also predicted that the Shanghai bourse could fall as much as 30 per cent from June 24 to mid-2016.
Strategists at BlackRock, Credit Suisse Group and Bank of America said last week that Chinese equities are in a bubble.
"I don't see this as the start of a bear run. Ultimately, the correction is good for the long-term health of Chinese stock markets because the government is trying to dampen excessive speculation in the market," IG market strategist Bernard Aw said.