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October 25, 2011 at 15:05 PM EDT
China Shadow Banking Crisis Could Dwarf Subprime Meltdown or Greek Debt Debacle
China's pervasive system of unofficial lending could become a poison extending far beyond its own borders.

China is taking some knocks lately over fears that a “hard landing” is in the cards for this booming emerging market. Admittedly, it all sounds a little overblown as China’s industrial output surged 13.8% in September over 2010 numbers — hardly indicative of an economic crisis. And although auto sales in China are lagging, they still are growing in what now is the largest vehicle market in the world after American car buying slowed to a crawl during the recession. And, of course, Macau casino stocks are booming as disposable income among wealthy Chinese continues to be in ample supply.

But those who watch manufacturing and consumer trends in China are buying into the head-fake. The fact is almost all production and consumption trends in this nation are subject to massive risks of Chinese banking and lending — a so-called “shadow banking” system that is unregulated, corrupt and wide-reaching in this communist nation.

Consider this: According to a study issued by the People’s Bank of China in 2010, non-banking-sector lending has expanded to anywhere between $1 trillion and $10 trillion — as much as 40% of the total lending activities of China’s economy. These loans come with exorbitant interest rates, ranging from 14% to as much as 70%.

The practice has become so widespread, in part, because it isn’t loan-sharking to gamblers and drug addicts. In China, it’s mostly rich individuals and legitimate businesses lending money to other individuals and even companies as an “investment.” The red-hot growth and inflationary pressures typically have meant repayment is within reach, so both the lender and the borrower alike wind up happy with the results of the arrangement.

But what happens when loans can’t be repaid? There is little to no government oversight for these loans, so there is little to no recourse when a debtor defaults. And unlike banks, which have a large portfolio of loans and assets to fall back on, individuals making these shadow loans sometimes can’t afford a 100% loss that bites into their savings or family budget. It becomes a domino effect, where one person’s loss becomes another’s, cascading around China one lender and business at a time.

China Addicted to Shadow Banking

China recently has pledged more oversight and regulation of the shadow banking industry, but it’s not that simple. The bottom line is that China has a vested interest in this kind of lending.

The surge in lending in China is closely tied to a sharp rise in property prices. As in the U.S. before the financial crisis, it appears the Chinese have embraced the idea of loose credit to buy property as an investment.

But we learned the hard way that those investments aren’t guaranteed.

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