By Cyrus Sanati
June 26, 2013

FORTUNE — China’s over-leveraged banks may be the least of the nation’s economic problems at this point. What has traders from Hong Kong to Wall Street truly worried is the state of the nation’s so-called shadow banking system, where the government has little, if any, real control. Unless China is able to rein in the reckless spending and bogus claims in this shady corner of the market, it could soon face the wrath of millions of angry and defrauded investors.

Chinese markets have been taken for a wild ride in the past week thanks to aggressive monetary actions by the Chinese government in an effort to rein in what it believes to be “excessive speculation” in its banking system. Last week, China’s central bank, the People’s Bank of China, decided to basically shut off the monetary printing press, forcing the nation’s banks to fund themselves without fresh government cash.

Unfortunately, the government got more than it bargained for — interbank lending rates shot up to unsustainably high levels, at around 13% or four times the average rate (there have been reports they shot up to 25%). In any case, instead of curbing lending, the PBOC’s actions managed to kill it all together. Given that Chinese banks are reliant on interbank lending to support their operations (i.e. to service all those speculative loans) the PBOC had inadvertently put the solvency of the country’s banking system at risk.

Fearing a full-on credit crisis, the PBOC quietly relented last Thursday, flooding the system with cash through open market operations in the hopes of restarting the interbank lending market. Almost immediately, interbank lending rates fell back down to 6%, helping to avert a major credit crunch — at least for now. After rates stabilized, the PBOC sent out a statement on Monday saying it was getting tough on speculation and that it wouldn’t be supporting the interbank market as it had done in the past, which, while clearly not true, appears to be the financial equivalent of “saving face.” In any case, rumors of yet another PBOC intervention on Tuesday reversed a 5.3% plunge in the Shanghai stock exchange. The PBOC issued a statement later in the day reiterating its commitment to a tight monetary policy.

The government saying one thing and doing another seems strange to Westerners but it is old hat for China watchers. China’s markets and the way they operate is a reflection of life in China — nothing is what it seems. China’s banks seem autonomous, but at the end of the day are simply arms of the state. The Chinese aren’t going to allow the banks to fail — that could lead to the one thing the Chinese government is deathly afraid of: civil unrest. With a population of 1.5 billion, even a rebellion of just 1% of the population could mean curtains for the “People’s Republic.”

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Ironically, this is why the Chinese government took steps to curb lending in the first place. The newly appointed Chinese government, operating on a fixed 10-year term, is attempting to tame a monster born out of the previous government’s inaction — China’s out-of-control shadow banking system. This network of investment vehicles, known simply as “trusts,” hoovers up cash from ordinary citizens looking for a “safe” place to park their hard-earned cash.

To be sure, the trusts are nothing new — they have been around since 1979. Some are closely associated with the banks, with some operating in banking branches, while others have no banking affiliation at all. But what is new, at least in the last couple of years, is an explosion of securitized investment vehicles tied to trusts, all promising investors a much higher return on their cash than the state-controlled interest rate tied to bank deposits.

Why the sudden surge in rates? Easy — many of these trusts appear to be Ponzi schemes. The duration of these investment vehicles is usually just a few weeks or months, so they constantly need to be refinanced. That’s hard to do given that many of these investment vehicles are tied to illiquid investments, like property. Nevertheless, it is almost impossible to know what exactly most of these funds invest in given the total lack of regulatory oversight thanks to scant disclosure requirements. They could be backing solid real estate deals as benign as an apartment building in a high-demand neighborhood in Harbin or as sinister as yet another empty office tower in Shanghai’s Pu Dong district.

This sounds all too familiar. After all, it is this same sort of excessive speculation in the U.S. property market that triggered the global financial crisis in 2008. But the Chinese version of this scenario is far worse. The money being sunk into these shady schemes isn’t coming from global financial institutions; rather, it is almost exclusively coming from the ordinary Chinese citizen. Deposits at Chinese banks have plummeted in the last two years as people have pulled their money out of their checking and saving accounts and deposit it in these shady investment vehicles. Since they have short durations, the Chinese investors hope that they won’t be caught holding the bag when the proverbial music stops playing.

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This is super-dangerous, especially in a developing nation where there is no real social safety net. If you lose all your savings in China, you are on the street — and despite China’s “socialist” rhetoric, you are on your own. A bunch of newly poor and angry people on the street isn’t conducive to maintaining order, which, above all else, is the superseding goal of any Chinese government. Failure to maintain order in a country of 1.5 billion can be disastrous and could bring a rapid end to years of self-interested “central” planning, which, over the last 20 years, has enriched China’s ruling class and which has also taken millions out of poverty. The Chinese have looked the other way as their government ruled with an iron fist because of this prosperity. But millions falling back into poverty, while the ruling class remains rich, voids this social compact, which could lead to chaos.

China’s new government is deathly afraid of this outcome, hence the actions it took this week to pull liquidity out of the money markets. But this only serves to hurt the state-controlled banks, not the trusts, many of which get their cash from investors’ wages, not the government. How then can the government stop the trusts? The best way is to ironically take a page from the U.S. and nationalize many of them and guarantee their payout to investors. This is obviously an expensive proposition given the size of the shadow banking system, estimated by Fitch to be some 60% of China’s GDP, or around $4 trillion.

Can China absorb such a hit? Well, first off, not all the trusts are worthless. If, say, 30% of the loans are bad, which would be equivalent to the percentage of loans that went bad in the last major Chinese banking crisis in 2000, then the government may be looking at around a $1.3 trillion bailout. The PBOC can easily print that cash no problem. Indeed the solution to curing this crisis isn’t turning off the printing press, it is to ramp it up. But instead of funneling it to the banks, the cash needs to go to support the trusts before they fail. After the trusts are secured, China needs to finally get control of its financial system — not by literally “controlling,” it but by establishing or enforcing common sense regulations to protect investors from fraud. That means U.S.-styled disclosures, which, while not perfect, are better than whatever the Chinese have now.

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