02:24 - Source: CNN
Market selloff: Is the shoe about to drop in China?

Story highlights

Shanghai share prices have lost almost 40% of their value since mid-June

Stock rout raises fears for China's and the world economy

Hong Kong CNN —  

READ: China is taking 10 huge actions to save its stock market

Almost 10 weeks into a hot and troubled summer and the Shanghai market has taken another lurch downwards – it has now lost nearly 40% of its value from its peak on June 12.

But this time the sell-off is not an isolated incident in global stock markets. The latest Shanghai slump comes as the rest of the world starts to worry about the state of China’s economy.

A key index released on Friday showed Chinese factory output at its weakest level for 77 months. That triggered a global stock sell-off as investors fretted over the real state of China’s economy.

READ: China’s woes in two minutes

And that slump washed up on Asia’s shores Monday morning, led by the benchmark Shanghai Composite tanking by more than 8%.

So why are stocks falling?

Earlier this year, China’s stock market was displaying many of the classic warning signs of a bubble.

Grandmas, cab drivers and college kids were all making small fortunes in a frenzy of “chao gu” or stir-frying stocks – Chinese slang for trading.

And the stock rally came at a time when the wider economy was slowing, puzzling many financial analysts. But now they say gravity is taking effect.

“China’s stock market had become detached from the reality of China’s own economy, and appallingly overvalued,” Patrick Chovanec, managing director at Silvercrest Asset Management, posted on Twitter.

READ: Over half of China’s stocks have stopped trading

China is throwing the kitchen sink at the problem

While some analysts believe that the stock market is undergoing a much needed “correction,” China’s government has pulled out all the stops to support share prices.

The People’s Bank of China has cut interest rates to a record low, brokerages have committed to buy billions worth of stocks, and regulators have announced a de facto suspension of new share listings.

Dong Tao, chief economist for Asia excluding Japan at investment house Credit Suisse, said Beijing fears that the stock rout could undermine consumption, as people nursing losses are unlikely to go to the mall and spend.

“That creates all kinds of risks for the economy and for the financial system and this is why Beijing is worried,” he said.

Investors clearly aren’t convinced by government efforts. China’s stock market has been on a roller-coaster ride, sometimes opening with a jump of as much as 7%, before ending the day down by that much.

Monday’s trade is just the latest in that wild volatile ride.

READ: Economists very worried about stock market crash

How will it affect the rest of the world?

Few foreign investors have much direct exposure to these stock markets – only 1.5% of Chinese shares are owned by foreigners, according to Capital Economics, as China still limits the amount of overseas investment.

The real concern for those outside China is an economic slowdown and wider impact from a fluctuating stock market.

Fears of a downturn in China have already hammered the price of commodities like iron ore and copper this week.

In the longer term, this could also hurt places like Australia, which supplies of a lot of China’s raw materials.

READ: How media and risky trading fueled crash

What about Chinese people?

It’s ordinary Chinese that have been the biggest victims of the crash.

Millions of them piled into the market after regulations were loosened on margin trading – borrowing money to invest.

“I know people who sold their houses to invest in stocks. Now they’re finished,” one man told CNN outside a Shanghai brokerage.

However, the sharp recent losses follow a long rally, with both China’s two main stock indexes still holding on to gains if measured since the start of the year.

And economists say stocks only make up 15% to 20% of Chinese households’ wealth. This should help keep spending money in the pockets of consumers.

READ: Stock market crashes: How does China’s stack up?

What does this mean for China’s leaders?

President Xi Jinping has portrayed himself as a “strong man,” going after “tigers” – high-ranking officials – in his relentless anti-corruption drive.

But the stock market plunge could prove a formidable challenge to China’s top leadership.

“They’re putting their credibility on the line and if people see that they shoot that bazooka and, you know, the market continues to fall and then they realize that the government doesn’t control economic outcomes as much as they thought,” Chovanec told CNN.

And the heavy-handed measures Beijing has enacted to try and halt the rout may have undermined faith in China’s commitment to market reforms.

“The government wants to reverse the market movement – this is not market-based policy. That’s a big setback for the Chinese capital markets,” said Dong.

A version of this article was originally published on July 8. It was updated and republished on August 24.

CNN Money’s Charles Riley and Sophia Yan contributed to this report