Credit is what makes the commodities world go round.

Whether it be copper from Chile, oil from the Gulf or soybeans from Brazil, it all has to be shipped to consumers. This global flow of raw materials is facilitated and underpinned by letters of credit, the point where the worlds of finance and physical trade meet.

Over the last decade more and more of that flow has been heading to China to feed the country’s insatiable demand for the commodities it needs for industrialisation and urbanisation programmes.

But somewhere along the line, commodities trade financing started morphing into something else in China. Alongside the traditional use of letters of credit has grown a monster, a massive, complex, amorphous credit network that is nothing less than a shadow banking sector.

In its darkest recesses it is a world of hot money, fake invoicing and outright fraud.

As the metal markets have just found out.

Banks and traders are descending on the northern Chinese port of Qingdao to find out if the metal they have lent money against is really there and really theirs.

Back in London copper spreads have collapsed in fear that the mountains of metal sitting in China’s bonded warehouse zones, locked up as collateral in financing deals, will flood back onto the market.

Those fears are probably overblown, but no-one really knows. That’s the problem with shadow markets. You only really find out how big and perilous they are when something goes wrong.

THE QINGDAO PROBLEM

And something has certainly gone wrong in Qingdao.

It seems as if a local trading company has been caught using warehouse receipts to raise multiple loans on the same metal.

The details are still very sketchy and the metal may be alumina, aluminium, copper or iron ore, depending on who you talk to. Qingdao is a major port for imports of all of them and what started as a specific investigation has now mushroomed into a full-blown port audit, raising the possibility that others have been caught in the dragnet.

The markets are buzzing with rumour and speculation.

Western banks involved in this business such as Standard Chartered and Citigroup are “reviewing metals financing” deals and working “closely with the relevant authorities” respectively.

Chinese banks are equally worried, at least one sending a team from its head office to Qingdao to investigate.

They all share the same fear. Is this an isolated incident or the tip of the iceberg? Just Qingdao or other ports? Everyone’s thinking Shanghai, given its prominence in the copper collateral financing trade.

THE METAL PROBLEM

There are around 700,000 tonnes of copper sitting in the Shanghai bonded warehouse zone. Give or take 100,000 tonnes. It’s hard to say since this metal is not registered with any exchange and exists in the statistical twilight.

But it is, everyone agrees, the single largest concentration of refined copper anywhere in the world. It dwarfs the combined tonnage registered with the world’s main three copper-trading exchanges; the London Metal Exchange (LME), COMEX in the U.S. and the Shanghai Futures Exchange in China itself.

Much of it, probably most of it, is being used not for any manufacturing purpose but as collateral for lending and, often, re-lending.

Imported under longer-dated letters of credit, it underpins a multitude of shorter-dated loans, a metallic hub supporting an interwoven mesh of interest rate arbitrage, renminbi speculation and, not least, a punt on the price of copper.

As panicky banks react to the Qingdao probe by reducing their exposure to this collateral trade, there is understandable concern that all this copper will be unlocked from the financing deep freezer and wash back into the market place.

So far the LME copper price has done no more than wobble. But the real impact can be seen in the spread structure. The benchmark cash-to-three-months period CMCU0-3 was last week deeply backwardated, the spot price trading at a premium of $100 per tonne to the forward price.

That tightness reflected the simple fact that LME stocks are at multi-year lows because so much metal is located in China’s bonded warehouses. Today that spread is close to level as traders price in a potential mass relocation of copper out of China back to LME warehouses in South Korea and Taiwan.

And what of the 104 million tonnes of iron ore sitting at various Chinese ports? Some of it is almost certainly being used as collateral as well.

So far the iron ore price has hardly blinked but then it is already at two-year lows.

In fact iron ore has still not recovered from a ferocious sell-off in March, which was triggered by, you guessed it, concerns about collateral financing in China.

Then the culprit was a previously obscure solar panel maker called Chaori Solar, which made a little bit of Chinese history by being the first company to default on a domestic bond.

Nothing to do with iron ore you might think, until, that is, you factor in the credit sensitivity of all that stuff being used to collateralise the shadow lending sector.

THE CHINA PROBLEM

The reaction to the Chaori Solar default was a warning sign that something nasty may be lurking in the Chinese shadows.

It wasn’t the only one.

In April Chinese importers defaulted on at least 500,000 tonnes of U.S. and Brazilian soybean cargoes worth around $300 million. Local banks had pulled their lines of credit, at least partly in response to government directives to clamp down on commodity financing.

That particular incident shows how worried the Chinese authorities are themselves about what is happening in the shadows of the country’s import trade.

Indeed, they have been playing a protracted game of cat-and-mouse with collateral financiers for many months. Local banks have been repeatedly instructed to tighten lending criteria, while some of the more egregious practices, such as the eternal credit line, one that is renewed ad infinitum, have been stamped out.

But the authorities are also caught in a vicious circle of their own making.

China is still living with the side-effects of the massive liquidity injection it used to fend off the global financial crisis back in 2009. Faced with collapsing world markets for its goods, it unleashed one of the greatest stimulus packages ever seen. Money poured into infrastructure, property development and new production capacity in sectors such as steel, cement and aluminium.

Bloated industries became even more bloated. China’s steel sector, for example, is suffering from chronic over-capacity and collapsed margins. Parts of the commercial property sector are still bubbling away merrily.

Such hot spots are now being starved of fresh loans as Beijing tries to trim some of the historical excess. But in doing so, it is incentivising those targeted to raise money by other means, first and foremost from the shadow lending market that flows from metals like copper imported under low-interest lines of credit.

In other words, funds are being channelled to precisely those deemed too high a credit risk to qualify for normal bank lending in the first place.

A huge shadow credit system largely out of sight and reach of the financial regulators, resting ultimately on assets that would be classified as junk in the official sector? Sound familiar?

Outside of China the world is still living with the consequences of such systemic credit failings. China still has time to regain control of its own shadow credit market.

What’s happened at Qingdao is the clearest warning yet that it needs to act.