The fate of debt-ridden U.S. rare earth miner Molycorp rests on China's efforts to crack down on networks that smuggled as much as 40,000 tonnes of the vital technology metals out of the country last year, driving down global prices.

Greenwood, Colorado-based Molycorp is the sole U.S. domestic supplier of rare earths used in everything from smartphones to military jet engines and hybrid vehicles.

In 2011, it relaunched its huge Mountain Pass mine in California expecting prices to stay high after China, which dominates world supply, restricted exports. Last month it filed for bankruptcy protection as operating losses mounted.

Customs police in the eastern Chinese port of Qingdao last month arrested five traders following a nine-month investigation into a rare earth and ferromolybdenum smuggling ring worth nearly $18 million.

That was no one-off. Chinese authorities have been struggling since 2010 to smash an illegal supply chain in which rogue miners deliver ores to unauthorized separation facilities, with the finished products then disguised and shipped abroad.

"Traders go through all kinds of channels and make false product declarations at customs - marking it as alumina or even washing powder," said Chen Zhanheng, vice-secretary general of the Association of China Rare Earth Industry.

According to industry estimates, around 40,000 tonnes of rare earth oxides were smuggled out of China last year, more than the official export volume of 28,000 tonnes. It has hurt overseas producers like Australia's Lynas Corp and Molycorp, whose business plans were built on China's efforts to restrict domestic supply and crack down on illegal production.

"Paradoxically, Molycorp's biggest supporters may be in Beijing," said David Abraham, director of the U.S.-based Technology, Rare and Electronics Material Center, who studies the politics behind the rare earth sector. "If authorities in China can reduce black market trade it would introduce enough market stability and an unofficial price floor that will go far in giving Molycorp the space it needs to restructure into a profitable company."

A spokesman for Molycorp declined to comment.

OVERSEAS RIVALS UNDERMINED

Cracking down on smuggling has been a priority in China since 2009, when authorities first turned their attention to restructuring an industry beset by disorder and regulatory failures.

Officials said China was not being properly compensated for its dominance in global supply, and its policies were designed to support prices and encourage 'value-added' downstream sectors. China controls around 90 percent of the world's rare earth supply.

Beijing vowed to restrict imports through a quota system and cap domestic production, justifying its policies to the World Trade Organisation by pointing to the environmental damage done by mining in regions like Inner Mongolia and Jiangxi.

But the smuggling has continued, keeping prices low and undermining overseas competitors, with traders saying it remains relatively easy for smugglers to hide small volumes of rare earth amid consignments of bulk commodities.

"These activities are still under the protective umbrella of local governments and in the past it wasn't easy to crack down on them. Many of the mines are small-scale and widely dispersed," said Chen.

With quotas and tariffs helping to create a price gap between domestic and international markets, many have expressed hope that removing quotas this year would cause prices to converge and cut the demand for smuggled material.

"Now there are no such limits and traders only need orders from overseas to qualify as an exporter, there is no need to risk smuggling illegally - there's no profit motive," said Chen.

But with China still imposing production caps and many large rare earth mines operating at well below full capacity, there is still an incentive for illegal producers.

China set an official production cap of 105,000 tonnes for 2015. If consumption remains at the 2014 level of around 84,000 tonnes, it would leave around 20,000 tonnes of official output available for export.

With established smuggling channels, many buyers preferred to take the illegal route, even when quotas were available. In 2011, exporters used just 61.6 percent of total quotas, with that figure rising to 91 percent last year, showing that exporters were still not using all their quotas.

China also continues to restrict the number of firms allowed to produce and export rare earths, meaning there will remain a significant supply bottleneck that is likely to encourage smuggling as well as illegal production.

"More so than smuggling, illegal mining and production of the concentrates is perhaps the most prevalent problem in China's industry and is a major reason why prices are low because there are abundant inventories that were never planned to exist," said Ryan Castilloux, founding director of Adamas Intelligence.