The Shanghai Composite Index, China's stock market benchmark, began a steady climb from 1,820 points at the start of the year to reach a high of 3,478 in August, a growth of 91 percent. Major volatility closely followed, though, pulling the index down to 2,639 before sending it up again recently, to 3,068. Before long, the index tumbled once again, down to 2,900.

The indexes suggested an upward trend in the national stock market during the first seven months of the year. Why, then, would a major downturn suddenly hit in August, especially when, at the same time, the US Dow Jones Index saw a fresh high, beating its performance just before the market crashed in September 2008.

In other words, while extreme challenges lay ahead for the international financial situation, the Chinese stock market had already begun its recovery, as evidenced by the soaring index. But, as the international markets became more stable and stock prices began rising, the Chinese stock market oddly started plummeting. The subsequent pessimism felt as a result of the volatility in turn affected some international markets, though not quite as seriously, and indexes like the Dow Jones began to climb after a temporary dip.

Another question we have is how long this volatility will last. The plunge at the beginning of August, according to market analysts, was a natural adjustment to the preceding upward frenzy. The present adjustment brought the index down from 3,478 to 2,639, a loss of more than 800 points, or more than 25 percent, a decline that is by all means too acute to go unnoticed.

In my opinion, two key factors contributed to the recent instability. First, the Chinese stock market has never freed itself from being capital driven – every large influx of capital would give the market an instant surge. From January to August this year, credit funds in China increased by 8.15 trillion yuan (US$1.193 trillion). Since the economy was in a healing process, a large amount of the funds that were originally aimed at financing large-scale national projects, went into the stock markets instead. When the capital was forecast to drain out in the second half of the year, the market almost immediately started to tumble.

In fact, the increase of credit funds during H2 so far isn't any different from that of previous years, and market liquidity is not expected to stagnate. With rumors of both, however, many investors have chosen to bail out of the wavering market, scared off by last year's turbulence. On the flipside, the financial hurricane has also instilled a sense of caution into numerous Chinese investors, who otherwise would have continued with a starry-eyed view of the stock market and eventually burst the market bubble. That's why last year's economic turmoil was still a positive thing for the stock market's long-term prosperity, despite the losses incurred.

The second factor is the government's excessive eagerness for instant success. Once there's a boom in the stock market, like during the first half this year, the authorities think it's time to have numerous state-owned companies go public.

Although basic improvements have been made to the Chinese stock market over recent years, the focus of "going public" has never shifted from "the enclosure movement" – getting fast funds, or as the tool to becoming rich overnight. Therefore, among the swarm of companies wishing to be listed, companies like the Chinese State Construction Engineering Corporation and Metallurgical Corporation of China, accompanied by the so-called Growth Enterprise Market, have been able to solicit as many as 10 companies to raise capital by floating shares in a single trading day. Not only are acts like this never a reflection of the market's prosperity, but they also cause panic, as market investors will inevitably perceive that domestic enterprises are once again rounding up their money, resulting in their subsequent escape. Financing giants like Vanke is just a case in point.

The current economy, both at home and abroad, are in the healing process. The US stock market has already seen steady climbing, while the Chinese economy is recovering at a better-than-expected rate. Meanwhile, listed companies report improved performance, and the domestic financial market has regained liquidity – all pointing to mounting momentum in the Chinese stock market during the second half of this year.

In light of the current state of the stock market, the authorities should pay close attention to drastic trends and institute the appropriate policies to guard the market against excessive risks, rather than purposefully upsetting the fragile market with harsh policies. And only by these means can the stock market resume its development, safeguarded by a well-meaning authority.

This blog was first published in Chinese on September 22, and translated by Maverick Chen.