[jyl]

Chinese economy has been accumulating a build-up of problems.
- Too much infrastructure investment. Can't keep driving the economy through big capital projects because they are running out of airports and roads and trains to build. So the first leg of an economy, capital spending, is slowing.
- Slowing export growth. The pendulum has swung about as far toward "made in China" as it can, I don't know that Mexico, America, Thailand, etc are taking or will take back that much manufacturing share, but China's share is growing more slowly, if at all. So the second leg of an economy, trade, is weakening.
- Slow to develop a consumer economy. I'm not completely sure why this is so, Chinese certainly like spending money and material things, but anyway the third leg of an economy, consumer spending, hasn't developed enough. The government is trying to encourage this sector, so it encouraged a huge property bubble which is slowly deflating, and encouraged a huge surge in automobile sales which is running into traffic/environmental jams.
- Excessive debt, more by local governments and state owned enterprises, but also by private companies. Over investment means the returns on investment is low, hence the debt issued for that investment is iffy. China also has very little effective regulation and lacks a reliable legal system, both necessary for a debt market. Finally, the Chinese government never wants a SOE or local government or bank to default, because it makes the government look bad, which means they always deliver bailouts, which leads to riskier debt.
- Aging population. A legacy of the one-child rule. China is aging faster very fast. Older population means slower growth. China is in a desperate race to get rich before it gets old. (Japan got rich and old at the same time. The US is both rich and relatively young, for which you can thank immigration.)
- Paranoid government, well that might not be the best word for it, but anyway the Chinese government feels always under threat. The bargain in China for the last 50 years has been government delivers ever-growing prosperity, citizens tolerate lack of freedoms/rights. So the government feels that it cannot let economic growth slow down. And the government seems to not fully understand markets and/or to over-estimate its ability to control markets.

So the Chinese government decided to develop the local (domestic) stock market in Shanghai and Shenzen. (This is different from the Hong Kong market.) Citizens would make money and feel prosperous, SOEs and other companies would replace debt financing with equity financing, China would gain prestige and supplant the US as the world's best stock market.

This required the local stock market to be a bull market, of course. So the government encouraged people to invest in stocks, permitted (encouraged) excessive levels of margin debt, discouraged bearish analysis or shorting, and did not require anything approaching reliable financial reporting/auditing.

So the domestic stock market in China soared in the last year, SHCOMP up from 2000 to 5200, driven by individual investors using lots of margin debt. This move was totally disconnected from fundamentals, was purely speculative. Individual Chinese investors, the stupid ones anyway, thought the government wouldn't permit the market to decline, because China's stock markets are "different". Bullish analysts said, sure, the P/E is 80X for companies with mediocre businesses in a weakening economy, but M&A and margin loans and government support and international investors will keep driving the market up.

My mom wanted to invest in the domestic Chinese market this spring, but I wouldn't let her. She would have been an example of the ignorant individual investor who is now losing their money.

What is going to happen?
- The government will pull out all the stops to support the domestic market.
- It will fail, I expect. Doesn't mean the market will go to zero, but maybe to 3000.
- Instead of stimulating the consumer economy, the government's scheme will cause Chinese consumers to pull back. More businesses, banks, and local governments will have to be bailed out, and the government will be less wiling to let any publicly fail.
- The government will tighten its control over the rest of the economy, not just financial but also on security and speech.
- The direct impact on other countries will be minimal. Very little foreign money is invested in the domestic Chinese market.
- The indirect impact on other countries will be modest. The Chinese economy has been slowing anyway, which has already impacted imports from the West. I don't think there are a lot of dependencies between Chinese banks and the Western banking system. Maybe it depresses oil prices and incrementally hurts the oil industry.