The Shanghai Tell; Last week's dip in China's markets has left Beijing more anxious about its economic control.

Byline: Sarah Schafer (With Melinda Liu in Beijing)

Depending on whom you asked, it started with a Chinese government order to local banks to stop lending to speculators. Or with a rumored new capital-gains tax. Or with inexperienced mutual-fund managers trying to undersell each other. But if the cause of last Tuesday's precipitous plunge in China's stock exchanges--Shanghai fell 8.8 percent, its biggest slump in a decade, and the smaller Shenzen dropped 9.3 percent--was unclear, the fallout was certain: a sudden jolt to markets from Tokyo to New York.

As many of Asia's markets continued to struggle late last week, stocks in China started to bounce back, highlighting just how volatile China's market has become--and just what a challenge it presents to Beijing, which is anxious to keep the country's hot, semicapitalist economy growing as it heads into the 2008 Olympics. The Shanghai and Shenzhen stock exchanges are critical to the ruling Communist Party's development plans, because they provide a channel for enterprising Chinese firms to raise capital and a way to gradually privatize inefficient state-run companies. But last week proved that a young stock market is an unpredictable tool of reform, even in the hands of a government determined to maintain order. If Beijing can't keep markets from overheating and fix underlying problems, it won't be able to create an efficient means of raising capital or imposing discipline on state-run firms.

China's stock markets, established in 1990, languished for years because of corruption, red tape and other problems. In March 2005, they almost collapsed, and new listings were suspended temporarily. But over the past two years, Chinese stocks have exploded, climbing 155 percent in Shanghai. Flocks of investors have followed, with new accounts tripling since 2005. The 1,400 companies listed on both markets now have a total value of about $1.4 trillion--mostly from domestic investors, since access to foreigners is limited.

Some emerging-market bulls believe that with recent reforms, China's markets are coming of age. But they are still plagued by fraud, weak corporate governance, poor transparency and an overwhelming bias toward secretive state firms, many of which allow only minority shares to be traded. The boom, skeptics say, owes mainly to the influx of money into China, a result of its trade surplus and undervalued currency.

With rising incomes, Chinese investors are turning to stocks, in part for lack of options. Individuals and many institutions are largely prohibited from investing overseas. China doesn't have much of a bond market, and its banks--where 90 percent of Chinese keep their savings--offer just 2 percent interest, not enough to keep up with inflation. Stocks offer a way to profit from China's boom, and investors are betting that the government won't let the market crash, especially not before the 2008 Olympics. Many officials (or their families) are deeply invested themselves, and worry that a crash could trigger ...