The US Federal Reserve's decision to exit from so-called "quantitative easing" - its massive monthly purchases of long-term assets - is stoking fears of a hard economic landing in China. But China's strong economic fundamentals mean that policymakers have the space to avoid such an outcome - as long as they bring the country's shadow banking system under control.

As it stands, Chinese consumption and investment growth is expected to remain at roughly last year's levels. Meanwhile, economic recovery in the advanced economies, especially the US and Europe, is reinvigorating external demand, leading analysts to project annual Chinese export growth of more than 10 percent this year - 3 to 4 percentage points higher than in 2013. This would bring annual GDP growth in 2014 to a very healthy 7.5 to 8 percent.

The problem is that China's financial sector has accumulated considerable risk in recent years, with broad money (M2) having ballooned to 110.7 trillion yuan ($18 trillion) - almost twice the country's GDP - at the end of last year. In an attempt to rein in M2, which could indicate that the economy is overleveraged, the central bank tightened conditions for commercial bank lending, so that, for any given increase in M2, less credit is extended.

But the move failed to contain M2 growth; on the contrary, M2 grew faster last year than in 2012. Worse, restricting commercial banks' role as financial intermediaries and encouraging the growth of unregulated shadow banking has generated even more risks for China's economy. Clearly, a new approach is needed - one that is based on a deeper understanding of the dangers inherent in China's banking system.

While it is true that surging M2 can reflect excessive leverage, it is not a particularly accurate gauge in China, where commercial banks can easily circumvent high reserve requirements and quantitative controls by moving loans off their balance sheets to wealth management products - practices that fuel artificial credit expansion that looks like M2 growth. In this sense, it is the Chinese monetary authorities' reluctance to open up the formal financial sector to domestic private capital, or to liberalize the deposit rate, that is fueling the expansion of shadow banking.

With small- and medium-sized enterprises (SMEs) - by far the economy's most important growth engine - unable to acquire sufficient funding from the formal financial sector, they have been forced to turn to informal channels. As shadow banking has become the primary source of finance for SMEs - which tend to be higher-risk borrowers - the financial risks in China's economy have grown exponentially.

Exacerbating matters, the central bank's repeated efforts to tighten the money supply raises the cost of capital. Last June, the annualized interbank lending rate surged to more than 10 percent - a level that it almost matched in December. SMEs ultimately shoulder these costs, diminishing their ability to contribute to overall economic growth.

Consider the Internet giant Alibaba, which began using Alipay, to raise money last year. In just a few months, it received 400 billion yuan from 85 million small investors. Tencent, China's largest Internet company, is now using the same strategy to compete with Alibaba, with both companies offering high rates of return to attract as many investors as possible.

The problem is that most of this investment is in the interbank market, meaning that SMEs ultimately face interest rates of more than 10 percent - and that does not include the added 3 percent for SMEs' loan guarantees. These unsustainable high rates are transmitting major risks to the real economy.

Nowhere is this more apparent than in the real-estate sector. Liquidity-thirsty developers, unable to acquire financing through the formal banking sector, have been taking out massive loans at extremely high interest rates. But, in many cases, housing demand has not grown as expected, raising the risk of default - the effects of which would be transmitted to the entire financial sector.

The fact is that China has never been closer to a major financial crisis than it is today. Yet China's monetary authorities do not seem to understand the scale of the risk - or its root causes.

The Chinese economy may well need to be deleveraged. But, instead of blindly tightening the credit supply, policymakers must pursue deep financial sector reform to liberalize the deposit rate, eliminate quantitative controls, and, most important, allow for the establishment of domestic private financial institutions.

Pursuing this agenda is essential to China's long-term financial and economic health. But doing so presupposes a major shift in Chinese monetary authorities' mindset. Therein lies the real challenge facing China today.