The Shanghai Composite index fell by as much as 4.1 per cent to 4431.6 in early trade on Friday, taking total losses from the previous day to more than 11 per cent, before recovering strongly  in the afternoon.

The gauge - which on Thursday morning was pushing hard towards 5000 points - tumbled 6.5 per cent on Thursday in a late turnaround after brokerages tightened lending restrictions and the central bank drained cash from the financial system.

A fall of more than 10 per cent is considered a "technical correction".

The Shanghai Composite's biggest loss since January comes before 23 initial public offerings tipped to lock up 4.9 trillion yuan ($US790 billion) of liquidity starting early June.

Chinese equity markets have been booming with some up by as much as 140 per cent over the last 12 months.

But the rapid growth has caused some volatility. Thursday was the Chinese markets worst day since January 19 when a crackdown on margin trading saw the markets fall 7 per cent in a single session.

The rapid decline has left many investors reeling and looking to understand the timing of the sudden decline.

Here are several factors that prompted the decline.

Sell-off of major bank stocks

One key event was China's sovereign wealth fund, Central Huijin Investment, selling off shares of two major banks, which caused significant price decline that led the market down.

The Industrial and Commercial Bank of China dropped 5 per cent and the China Construction Bank dropped 5.9 per cent.

Fidelity China Fund portfolio manager Jing Ning said this sparked a broader sell among retail investors following suit.

"Volatility is to be expected given that the A-share market had rallied more than 50% this year, yet not that much has changed fundamentally," Mr Ning said.

"The retail nature of the A-share market means it is prone to wild swings in sentiment. There will still be incremental demand for A-shares, particularly for large-cap stocks that still trade at reasonable valuation versus peers in Hong Kong and on global markets."

Overvaluation concerns

Another key factor raising concerns is the valuation gap between mainland and Hong Kong exchanges, with some trading up to a 30 per cent premium higher in mainland markets.

In an equity strategy note released by Nomura's global markets research, Chinese equity strategists said this was fuelling fears of overvaluation.

"We note that A-shares' continued optimism to date has been underpinned by a favourable liquidity outlook; with margin financing and interbank funding coming under new pressure, today's sell-off is perhaps overdue."

The Nomura team cited a range of other factors that raised oncerns including the Central Huijin stake sale, the People's Bank of China draining more than 100 billion reniminbi from the interbank market, and 23 upcoming IPOs.

Margin lending

Fears were further stoked by several mainland brokers tightening their margin financing. Changjiang Securities joined larger rivals GF Securities and Haitong Securities in increasing its margin requirement, the collateral put up by an investor when borrowing. The firm announced the increase to 80 per cent from 60 per cent late on Wednesday. Guosen Securities also tightened its rules.

This came after two other brokers had earlier in the week cracked down on margin lending.

Steep increases in margin lending have been an important contributor to the bull market rally. Alon in Shanghai margin lending by brokerages exceeded 2 trillion yuan as of May 27, five times the level of a year earlier, stock exchange data showed.

What Beijing wants

Nomura analysts added that investors were tracking the relationship between the central government in Beijing and the nation's fledgling equity markets, which could face significant government intervention if they develop in what Beijing believes is the wrong direction.

"Most investors that we have spoken to since April seem to believe that Beijing wants a bull market in equities so that it can monetise assets, create wealth effect, and help the real economy. But our checks indicate that, in reality, funding is exiting the real economy for A-shares, thus likely further aggravating the real economy at this point in time."

Nomurra's Chinese equity portfolio is overweight on equities in the property, technology, healthcare and utlities while underweight on local banks, diversiifed financials and capital goods.