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Shadow banking: China's wobbly house of cards

January 29, 2014: 11:47 AM ET

The prospect of the first major default connected with the Chinese shadow banking system sent shock waves through the financial markets of emerging economies. Expect more close calls to come.

By Minxin Pei

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FORTUNE -- Investors around the world have been wondering for a long time when China's shadow banking sector will collapse. This week, they almost got their answer.

A wealth management product (WMP) issued through the shadow banking system, seductively named Credit Equals Gold No. 1, was on the brink of default. The debt instrument, with a face value of 3 billion yuan (roughly $500 million), was raised from wealthy individuals to fund the purchase of coal mines in Shanxi province in 2011 and was due for full repayment on Jan. 31. However, the company that borrowed the money, the Zhenfu Energy Group, a private firm, had little cash left in its bank account. China Credit Trust (CCT), which issued the product on behalf of Zhenfu, would not stand behind Zhenfu's debt. China's largest bank, Industrial and Commercial Bank of China (ICBC), which sold this WMP through its branches in 2011, also rejected any responsibility for the default.

The prospect of the first default of a WMP connected with the Chinese shadow banking system sent shock waves through the financial markets of emerging economies. Fortunately, disaster was averted at the last minute. CCT announced that a mysterious "third party" had agreed to assume the debt. The investors would be made whole, even though they would have to give up two-thirds of their last interest payment. Based on Chinese press reports, the "third party" was likely CCT (China's fourth-largest trust company, which is majority-owned by state-affiliated firms), ICBC (a state-owned bank), and the provincial government of Shanxi (where Zhenfu is based).

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Among the many issues raised by this episode, two deserve special attention. The first is the hitherto undisclosed risks in China's shadow banking sector, which is estimated to have $6 trillion in outstanding loans. The second is the increased likelihood of a major default in the very near future.

Before the near-default of the Zhenfu debt, most analysts suspected poor risk management in China's unregulated shadow banking sector. The details that have emerged from this week's drama have confirmed our worst fears.

Back in 2011, Zhenfu's private owners, who had only 50 million yuan (roughly $8 million) in equity, wanted to purchase coal mining assets in Shanxi. Unable to raise money through the formal banking sector, Zhenfu turned to the shadow banking sector and the underground credit market and managed to raise a whopping 7 billion yuan (of which 3 billion came from CCT). When its WMP was issued by CCT through ICBC's branches in January 2011, Zhenfu promised to pay an interest rate of 10% per year. CCT reportedly pocketed a commission of 60 million yuan. ICBC made 120 million yuan in fees for selling Zhenfu's debt to its customers.

Unfortunately, Zhenfu's choice of acquisition targets and timing could not have been worse. The group was hoping to buy a large coal mine in Shanxi. But the mine's ownership was contested. Several other potential acquirers were also trying to purchase the same mine, and Zhenfu's bid failed. In the meantime, coal prices plummeted as a result of China's slowing economy, and the coal assets Zhenfu had already purchased at inflated prices in 2011 diminished in value. (Liquidating Zhenfu's assets today would not have paid its outstanding debts.) In May 2012, disaster struck. Wang Pingyan, the owner of Zhenfu, was arrested for "illegal fund-raising."

In retrospect, the Zhenfu story is a familiar tale of reckless financial gambling by individuals who used massive leverage (in this case, 140 to 1) and received help from key players in the shadow banking and formal banking sectors -- Chinese banks and trust companies. Senior ICBC executives from the Shanxi branch, for instance, lobbied hard for CCT to issue Zhenfu's debt. CCT's chief risk officer allegedly overruled his colleagues, who warned about Zhenfu's ability to repay the debt.

Although the Chinese government apparently dodged a bullet for now, the Zhenfu incident should trigger financial alarms around the world. Most WMP products have relatively short duration (one to three years). In 2014, about 5 trillion yuan in trust products alone will mature. Since the financial companies issuing the trust products have no capital to cover the potential losses (CCT has reserved only 80 million yuan for the 100 billion yuan in assets on its balance sheet), it is safe to say that there are many Zhenfus lurking in China's shadowy financial landscape.

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To deal with this impending tidal wave of default, Beijing needs to craft a more systematic approach that will use a combination of government bailout, debt-restructuring, liquidation, and recognition of investor losses. However, based on China's previous record of dealing with its banking mess, the most tempting response is to kick the can down the road.

This means that Beijing will likely order creditors to roll over the debt coming due this year -- until its bureaucracy develops a restructuring plan. It may be China's only short-term solution, but it will prolong the uncertainty, increase the risks within the financial sector, and inflate the ultimate costs of a bailout.

So, even though this house of cards may not collapse right away, it cannot stand much longer, either.

Minxin Pei is the Tom and Margot Pritzker Professor of Government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States

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