In the New Republic, Joshua Kurlantzick says:

In recent years, Chinese investors' confidence has been repaid by dramatic run-ups in the Shanghai exchange, which in 2007 was the best-performing major index in the world, rising a staggering 97 percent in one year alone.

But now the flaws in the Chinese markets are starting to surface. China's major indexes have already dropped more than 15 percent off their highs last fall, and could fall far further. Because of China's weak enforcement, most companies on the Shanghai exchange reveal precious little about their structure or finances, which was fine with local investors when the market was booming, but tells them nothing about whether these firms are really viable now. As two of my colleagues at the Carnegie Endowment, Minxin Pei and Wayne Chen, note, state-owned brokerage companies, rather than international financial firms, dominate trading in the market--yet these Chinese companies have been linked to repeated scandals. Insider trading and other scams are endemic to the Chinese markets, and generally bring little real punishment.

Just like its stock markets, China's banking sector retains a distinct Wild West flavor. Still forced to lend to companies with prime political connections but little financial prospects, many of China's banks are swamped with non-performing loans. To take one example, in 2006 the Agricultural Bank of China, one of the Big Four banks in the country, revealed that 23 percent of its loans were non-performing, a staggeringly high rate that forces the bank to constantly use capital to write off these NPLs. In comparison, 0.26 percent of Bank of America's loans were non-performing at the time.

Fifteen years ago, none of this would have mattered to the world; China's economy was a blip, it was isolated. But now that it's growing precipitously--holding vast currency reserves and heavily investing across the globe--its financial problems are our financial problems. Last February, for example, the Dow dropped over 400 points after rumors of a government crackdown on illegal trading, not to mention worries about an over-inflated market, prompted a major sell-off in China.

What's more worrisome when you consider last week's financial tumble is that many Chinese investors have never experienced a downturn before and do not have their money managed by large, calm institutional investors. They are likely to pull out of their stocks rapidly, adding to the anxiety across global markets. Panic among urban Chinese will likely also cut into their consumption, which will impact big American companies like General Motors and KFC, which have both built their long-term growth strategies on selling in China.

To read more:

http://www.tnr.com/politics/story.html?id=9c92d667-c745-4f80-9f2a-d7e0685a6278