Avner Mandelman is chief investment officer of Acernis Capital Management Inc.

A few years ago, before they became well known, I wrote about China's ghost cities – square miles of empty condos and shopping malls – after hearing about them from Canadian engineers working there. Which banks carried the mortgages on these empty husks as assets? I wondered. And how will these mortgages be paid?

I was later told by other informers about mountains of washing machines and fridges, produced just to keep Chinese workers employed – more evidence of misspent savings and misallocated resources. Which balance sheet will write off the needless goods? I asked.

Story continues below advertisement

The China experts I consulted told me not to worry. The Chinese economy was so huge that such mal-investments would easily be covered by future profits.

Well, apparently not. The Chinese market has crashed. Are these mal-investments coming home to roost, or is the government the culprit for having promoted stock ownership, leading to mass levered margin purchases by neophytes?

All contributed. But in my opinion, the real cause of this crash is different – and worse.

If we view modern China as a public company and its stock market as its share price, it becomes clear why this price is crashing: "Management" (Chinese authorities) just issued a new set of rules taking away too many of shareholders' rights. So the shareholders are voting with their feet, and selling.

I have not participated in the Chinese stock market's rise and fall, just as I have not participated in the Russian stock market's rise and fall. Neither country fulfills my three rules for investing abroad:

First, you must be able to walk down the capital city's main street, carrying a placard calling the ruler a fool, and the police won't molest you.

Second, if any citizen tries to molest you, the police will protect you.

Story continues below advertisement

Third, if you have a dispute with the government, you must be able to take it to court and, if you are in the right, have a reasonable chance of winning.

Absent any of these conditions, I would not invest. And neither should you.

Why? Because the first two rules define freedom of action and debate, without which private property cannot be created and enjoyed. The third defines property rights: Without enforcement of such rights by independent courts, "property" is meaningless. The authorities can take it away from you any time they want, and you'll have no recourse.

This is the case in Russia, where multibillionaire President Vladimir Putin allows others to become minibillionaires, but he can take away their wealth any moment he wishes, because no court in the land dares to tell him otherwise.

In China, property rights seemed stronger. But this wasn't because the law protected owners well. It was because the dictatorial authorities showed temporary indulgence when it suited them. However, that indulgence is now gone. A recent message in the official press told foreign companies that they have been "spoiled" by having too many freedoms and rights, and in future must toe the line more rigidly. In effect, such companies may have to serve political ends more than commercial ones.

This, in my opinion, is the prime reason the Chinese stock market is crashing. There is plenty of academic research demonstrating that when a company's directors limit shareholders' rights, their stock underperforms.

Story continues below advertisement

The same is now happening in China Inc. – property rights have been curtailed. If further proof was needed of the government's mindset, it was that even as the market crashed, the government disallowed selling, thereby yanking away one more thread of that fundamental right.

Now that the Chinese government is propping up the market, you might ask, won't this guarantee a rise? Couldn't it still be profitable to plunge in?

My advice is: Don't. The Chinese market is unlikely to recover meaningfully until the government loosens up its new edicts, and the experts I've spoken to don't think it will.

Now, why should we care about the Chinese market? Once again, there are three reasons:

First, Canada sells commodities to China. So if the Chinese economy weakens in the wake of the market crash, our TSX can catch pneumonia. This may have already begun.

Second, China is not the only country just coming to terms with worthless assets carried at inflated value. German banks have loads of bum IOUs from Greece, Portugal and Spain that will likely never be paid. Sooner or later, the banks must write them off. When they do, their lending ability may be curtailed and Europe may fall into recession. If this coincides with a resumption of the Chinese market's fall, it won't be pleasant.

Story continues below advertisement

Third, a new president in the White House always gives the economy an intestinal cleanse in the first two years, to get it moving in the last two in time for re-election. The market usually anticipates this by a year.

So a confluence of Chinese market plunge, German banks' debt writeoff and a tighter Fed may tip the world into a slump.

How can you protect yourself?

Avoid Chinese stocks, many European stocks and most resource stocks. And if you can, hedge, and carry extra cash. In the next two years, pure long positions could be painful.

In stocks you do own, learn all you can about management and directors as people, to be sure they're unlikely to enshrine their positions at the expense of your rights. Because if they do, like China's rulers just did, they risk seeing their stocks crash.