Waves from China’s stock market decline are lapping U.S. and global markets. Investors are concerned that any slowdown in China’s economic activity may hit the global economy, slowing growth, trade, commodity prices, inflation, and capital flows.

Yet the impact on China’s economy from the market decline has been muted so far. That said, to the extent that wealth losses have occurred and uncertainty has risen, Chinese may increase their already high-saving rates, reducing consumption and slowing growth.

The financial effects from the market decline may be greater. The consensus view is that margin loans are modest relative to the size of the banks (around 1.5% of total banking assets), implying the risk of a major financial crisis is limited. But there are reasons for caution:

What's behind China's market plunge?

First, the amounts involved may be much larger than expected. The amount of official margin debt extended by securities companies of $250-$300 billion may only be a fraction of the real level of stock-secured debt. Once umbrella trusts, private lending arrangements and the like are included, the amount may be 50%-100% greater.

Second, the exposure of the banks is greater than commonly assumed. Around 60%-70% of all lending in China is from banks. While precluded from direct exposure to stocks, banks have significant exposure to securities companies, brokerages, investment funds, and trust companies that provide margin financing. Banks also finance listed companies where the collateral securing the loan is stocks. General purpose bank loans to household and companies may have been used to buy stocks. Problems in these areas may emerge over time.

Third, the official permitted level of leverage is a modest two times, or loans totaling 50% of the value of the stocks. In reality, real leverage is higher, at least double the leverage to four times, or loans totalling 25% of the value of the stocks. In addition, the system involves multiple layers of leverage. Investors would borrow funds from banks using borrowed funds as the capital to purchase shares on margin.

The financial exposures derive from an essential circularity in authorities’ engineering of the stock boom.

The intention was to use higher stock prices to allow heavily indebted entities to raise equity to pay back otherwise unsustainable borrowing, in effect reducing the risk of loss of banks. Instead, the banks were lending money directly or indirectly to investors to buy shares where the proceeds may have been used to pay back the bank. In reality, the banks had just exchanged risks, without necessarily reducing the risk of loss.

The market’s decline has further compounded this circularity. China’s biggest state-owned banks, under government encouragement, have lent more than $200 billion to the country’s margin finance agency to support share prices.

“ The increase in China’s debt by more than $20 trillion since 2007 reflects around one-third of the total rise in global debt during that time. ”

The real damage is subtler, bringing into question the fundamental economic model, the reform agenda, and the authority of China’s leadership. Instead of diverting attention from existing challenges, the stock market correction has drawn attention to challenges, such as the end of property boom.

Chinese real estate represents around 23% of GDP, about three times that of the U.S. at the height of its property bubble. Prices appear inflated relative to incomes and rental yields.

Despite vacancy rates topping 20% and inventories equivalent to five years’ worth of demand in some cities, new housing starts are around 12% above sales. In China, investment spending as a percentage of GDP is unprecedented in history, creating massive overcapacity.

The accompanying credit bubble remains an immediate concern. By 2014, total Chinese debt was $28 trillion (282% of GDP), higher than comparable levels in the U.S., Canada, Germany and Australia, for example. In comparison, China’s debt was $7 trillion (158% of GDP) in 2007 and $2 trillion (121% of GDP) in 2000.

The increase in China’s debt by more than $20 trillion since 2007 reflects around one-third of the total rise in global debt during that time. The problem is compounded by the use of this debt to finance assets with inadequate returns to meet interest and principal repayments.

While in isolation a significant but perhaps manageable problem, the stock market decline — could ultimately affect China’s potential growth and, accordingly, global economic activity. This concern is reflected in significant falls in global resources stocks, as investors anticipate a slowing demand for commodities.

The episode may slow down or defer necessary economic reforms. The fear is that China’s proposals are rhetoric, designed primarily for foreign consumption. At the 2013 Third Plenum, the Communist Party stated that market forces must play a “decisive role” in allocating resources. The stock market crash and the response suggests that the Chinese authorities are likely to resort to tried and tested command and control measures when events develop in an unwanted way, relying more on communist dogma than market forces.

The stock market crash has drawn attention to China’s underlying repressive economic processes. China’s financial system is predicated on directing savings of ordinary Chinese into areas for policy purposes, especially maintaining economic growth. The regime relies on keeping the cost of funds artificially low usually below inflation rates. The system allows Communist Party connected firms and privileged insiders to benefit.

The stock market boom allowed elites to access cash from Chinese savers. The first group who benefitted were those who were able to list or sell shares to take advantage of artificially high prices. The second group were those who gained preferential access to shares in hot listings or benefitted from private information about earnings and corporate actions.

The fall in stock prices affects both groups. The financial elite are deprived of easy money-making options, especially as other sources of profits such as property become unavailable. Ordinary savers encouraged by the government to invest in stocks face large losses, increasing resentment at the nature of the game and growing wealth gap.

Last April, when the Shanghai stock index rose above 4,000, the Chinese Communist Party through its media organs trumpeted the new “Chinese Dream,” an essential part of which was increasing prosperity from rising share prices. That dream may become a nightmare for China, its investors, and especially its leaders.

Satyajit Das is a former banker and the author of the forthcoming “A Banquet of Consequences’”(in Australia and Europe); “Age of Stagnation” (North America and Asia). This article is the last of a three-part series.