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Chinese regulators are demanding that the nation's banks undergo stress tests which include being able to survive a 60 per cent fall in house prices.

That's a bit like making construction companies stress test buildings for an earthquake at 9+ on the Richter scale. It is both worrying and reassuring in equal measures.

One the one hand it is good that China is making its banking sector plan so prudently. In the wake of the mess Western banks made of a property boom last decade they certainly have a fine example of what not to do.

On the other hand the fact they feel the need to push stress tests so far indicates just how seriously the Chinese Government is now taking the threat of a property crash.

There wouldn't be any point stress testing local banks to that degree.

It hard to imagine how any Australasian banks could survive a sudden 60 per cent slump given the enormous reliance on the home mortgage market.

Thankfully the chances of that kind of slump are pretty remote given the way the financial crisis has slowly squeezed the air out of the local property bubble.

And our boom - even its peak - wasn't a patch on the Chinese version.

Bloomberg reports that State-controlled banks went on a US$1.4 billion lending spree last year after the Government pumped US$585 billion into the economy.

That caused residential real estate prices to spike by 68 per cent in the first quarter of this year, compared to the same period in 2009.

The Chinese banks won't actually fail of course. Most are state-owned and the cash rich Chinese Government would not let that happen.

But a property slump would change dramatically change their behaviour. Foreign investment would be rapidly curtailed, domestic lending would be slashed and demand out of China for Western commodities would fall fast.

That would be bad news for the global economy at anytime, but right now with US and European banks still struggling back to their feet, it would be devastating.

The upside of the tough stress tests -and perhaps the ultimate point of them - is that they will put pressure on the banks to ease back on lending and keep more capital in reserve.

In theory the Chinese state should have much more power than its Western counterparts to deflate this bubble in an orderly manner. But when it comes to economics, theory and reality have never been bigger strangers than they are now.

China is in uncharted waters and there is a growing risk that this property bubble could challenge even the might of the great one party state.

Perhaps a better stress test for local banks would be to look at how they would cope with a 60 per cent slump in the Chinese property market.

If the Chinese banks are preparing for that possibility shouldn't we?

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