Wednesday, July 28, 2010

China Heading For Its Own Credit Crunch

I recently blogged about China's hankering for its own flavor of faked financial stress tests. It will need to test a much wider swath of its financial community if its local governments are insolvent:

Chinese banks lent huge amounts of money to provincial financing vehicles for construction projects after Beijing called for nationwide efforts to spur the economy.

But now only 27 percent of projects financed by the loans are generating adequate cash flow for repayment, the Century Weekly said in its latest issue, citing the China Banking Regulatory Commission.

A quarter of a trillion dollars worth of bad development loans is a pretty serious chunk of change.  One set of insolvencies will trigger cascading defaults.  China is also about to experience the same loss of confidence in its bond rating system as the U.S. suffered in 2008:

Credit ratings assigned to yuan- denominated bonds issued on behalf of local governments in China are misleading and don’t reflect risks investors face, Dagong Global Credit Rating Co.’s chairman said.

How soon we all forget.  Investors should wonder whether any investment can be trusted if solvency tests and credit ratings are rigged to deceive even sophisticated professionals.  The best alternative to reliance upon opaque methodologies is one's own experience.  Do your own research on a bank's capital adequacy and double-check your numbers.  Make your own assessment of a bond issuer's solvency and double-check your numbers.

Full disclosure: Long FXI with short puts and short calls.