Source: The New Republic

As far as money watchers are concerned, the best part about last week is that it's over. The global economy was shaken. The Dow was maddeningly erratic. Jim Cramer looked to be even more addled than usual. As a result, Americans are as afraid for their economic future as they have been in years, with 75 percent thinking a recession is coming this year, or has already arrived. Always in need of a scapegoat, American politicians on both the left and the right have taken to lashing out at a familiar enemy: China. "China continues to violate the rules of the global trading system," AFL-CIO Secretary-Treasurer Richard Trumka said earlier this month, echoing past statements by Senators Chuck Schumer and Sherrod Brown, among others. "President Bush refuses to take action, fiddling away while the U.S. economy burns." Outbursts like that aren't unjustified: With pools of low-cost labor and weak rights protections, China has decimated the American manufacturing sector. It has also amassed the world's largest currency reserves, over $1.4 trillion, not by playing by the rules, but by allegedly manipulating its currency to keep exports cheap.

Still, as the world is beginning to find out, the biggest economic threat from China isn't its dominance of manufacturing or its artificially pegged currency, both of which we've known about for some time. It's that the world's soon-to-be third-largest economy is being fueled by financial markets that remain essentially--and dangerously--lawless.

Since 1990, the Chinese government has put much effort into promoting its Shanghai Stock Exchange, positioning it as a potential competitor to the Hong Kong Exchange and Tokyo's Nikkei. (China also has a third stock exchange in the southern city of Shenzhen.) So far the effort has paid off. As average urban Chinese have gotten richer from the country's rapid economic growth, they have jumped onto the day-trading bandwagon with gusto. On a recent trip to China, nearly every urban professional I met in Shanghai and Hangzhou was day trading in his or her free time, and there are now as many as 100 million Chinese brokerage accounts

Problem is, most of these new traders on the Shanghai Stock Exchange know virtually nothing about investing, and believe that because the government wants the exchange to succeed--and will not tolerate a collapse before the Summer Olympics--the market simply cannot fail. The link between the Chinese government and the Shanghai Exchange is seen as inextricable, and so far, that has mostly been a boon. 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.

Meanwhile, as the Chinese government rushes to shore up its banks and state-linked companies, it must spend down some of its vast currency reserves, possibly reducing its purchases of U.S. Treasuries. Such a move would prove disastrous for the American economy, which relies on those purchases to stay afloat. Given America's tiny savings rate, without Chinese purchase of U.S. T-Bonds, the American economy would likely go into a downturn so severe, well, it's best not to think about it right now. Simply put, the world cannot afford for that to happen. China matters too much to the global economy for its markets and banks to be run with all the opaqueness of a bookie's office.

Joshua Kurlantzick is a visiting scholar of Carnegie Endowment for International Peace, and a special correspondent for The New Republic.