'A correction was expected since speculative funds, including a large amount of hot money, have been looking to cash out,' said Bohai Securities analyst Zhou Xi. 'A severe single-day drop proved the funds were desperate to exit.'

Yesterday's drop was the largest since August 31 last year when the index fell 6.74 per cent. It was also the first time this month that the index fell below the psychological 3,000-point level.

With yesterday's drop, the index lost 4.6 per cent for the week.

The central bank raised the reserve requirement ratio for all banks by 0.5 percentage point on Wednesday, fuelling expectations that interest rates would be increased for the second time this year.

However, the Shanghai index still added 1.04 per cent the next day, closing at 3,147.74.

Analysts said yesterday's slump probably marked a new start of a bearish stretch after a liquidity- driven rally since September 30.

The index climbed 20.6 per cent between September 30 and Thursday, buoyed by an influx of fresh capital amid a strengthening yuan.

'The rally ran out of steam and a correction was inevitable,' said Shenyin Wanguo Securities analyst Wei Daoke. 'It won't be a surprise if the market continues to go downhill in the weeks to come.'

The recent rally was the result of hot money inflow rather than an improvement in fundamentals, analysts said.

The mainland economy is grappling with rising inflationary pressures that could lead to a hard landing, prompting Beijing to tighten monetary policies to contain asset bubbles. Consumer prices in October were up 4.4 per cent from a year ago, beating consensus predictions of 4 per cent.

As of yesterday, the Shanghai index was 8.9 per cent lower than the close of last year. Optimistic investors had expected the index to recover its lost ground earlier this year when an influx of capital flooded the stock market in September.

Last week the index, once one of the world's worst-performing, was nearly 30 per cent below its level in June last year.

In Hong Kong, the Hang Seng Index tracked the correction across the border, dropping more than 200 points in its 90-minute afternoon session to finish down 477.72 points, or 1.9 per cent, at 24,222.58. Nearly five blue chips declined for each that increased.

The index fell 2.6 per cent on the week after notching up a 7.7 per cent advance in the previous week. Trading turnover has held up, however, topping HK$100 billion yesterday for the 14th time since the start of October after doing so only twice in the first nine months of the year.

Danny Yan, a fund manager at Taifook Asset Management, said he expected trading turnover in Hong Kong would remain heavy for the rest of the year despite yesterday's sell-off on the mainland.

'Looking at the medium term, fund flows have nowhere to go,' Yan said. 'But given that there could be more hostile measures from China's central bank, Hong Kong domestic stocks should outperform.'

Friday blues

Shanghai Composite Index: -5.16%

Shenzhen Composite Index: -6.12 %

Taiwan Taiex Index: -1.43%

Jakarta Composite Index: -2.1%

Nikkei 225: -1.39%

Hang Seng Index: -1.93%

Thai SET: -1.07%

SOURCE: BLOOMBERG