Be scared of China’s debt, not its stocks

China’s stock market is crashing again. After two days this week with big and rapid declines— the latest of which shut off trading only a few minutes after the open— Chinese stocks are back in the neighborhood of their mid- 2015 lows. The raft of administrative measures that the Chinese government has used to prop up its markets since the big plunge last year seems to only have postponed further declines, rather than prevented them.

U. S. stock markets have also fallen a lot, probably as a result of the Chinese decline. Perhaps investors were expecting U. S. corporations to make fortunes selling to the Chinese market. Or perhaps leveraged investors, hurt by the Chinese crash, are selling U. S. stocks to keep their total leverage low. Maybe large stock market crashes just generate waves of free- floating pessimism.

Whatever the reason for the latest selloff, the big question is what the stock- market crash means for the Chinese economy. For more than a decade, the Chinese economy has been the engine of world growth, so if it grinds to a halt, countries that depend on trade with China may be in for a serious recession. If the slowdown is only mild, the danger obviously is less ominous.

If a stock bubble and crash were China’s only problems, the danger might not be so great. Research shows that bubbles are less damaging to the real economy when they mostly involve equity rather than debt. Debt crashes inflict harm on the financial system, creating major recessions that take years to repair. Equity crashes, meanwhile, merely reduce paper wealth. A good example of an equity bubble that wasn’t very harmful was the late 1990s U. S. dot- com boom. When it ended, stock prices were devastated, but the crash led to only the mildest of recessions.

The problem with China is that the stock market crash looks like it’s only the most visible sign of a much deeper and broader distortion in the country’s financial markets. Chinese property prices, while they have fluctuated from year to year, fell steadily in late 2014 and most of 2015. The long- anticipated deflation of the Chinese housing market may finally be at hand.

China probably also has a debt problem. Chinese banks, local governments and many companies have relied heavily in recent years on various debt instruments sold directly to individual Chinese people through a system of so- called shadow banks. In a typical arrangement, a bank will set up a trust company that borrows money from individual investors by selling them securities that are, in effect, high- yield junk bonds. The proceeds from these bond sales are then invested, usually in real estate or in companies related to real- estate development, such as construction.

This shadow banking system has enabled a large buildup of bad debt, much of it related directly or indirectly to real estate. If property prices fall, trust companies will go broke, and banks — having invested in the trust companies— will be on the hook. That will create the conditions for a really destructive crash.

In that case, the stock market gyrations we’ve seen might simply be a sideshow to the underlying debt- and- housing cycle. China’s stock markets began to soar in late 2014, just as property prices began to tumble. Investors may have been looking for some alternative to the housing market. Those investors probably pushed prices to unreasonable levels, which in turn likely drew in speculators looking to ride the wave of momentum. A crash at that point becomes unavoidable.

So China’s stock market might simply be a symptom of something much bigger and more troubling going on beneath the surface— the end of a huge property- based debt- fueled boom. That happened in Japan in the late 1980s— the Nikkei 225 bubbled and crashed, but it was the long, slow, debt- powered rise and fall of the housing market that really undermined the Japanese financial system.

There is good reason to be worried about the performance of the Chinese economy. How much its woes will affect developed economies is another question entirely— and it’s the one

everyone wants answered.