Now that’s a stress test.

Bank regulators in China said on August 5 that the country’s stress test of its banks will include a worst-case drop in real estate prices of 50% to 60% in the country’s most speculative markets.

Take that Euro Zone and even the United States where stress tests of the banking system that showed just seven and 10 banks, respectively, needed to raise additional capital have been widely criticized as too lenient.

But before you start cheering on the news that a country is finally getting tough on testing its banks, consider this possibility: China is publicizing how tough its test will be not because it thinks its banks are in good shape (and will pass an honest test) but because is becoming increasingly worried that investors are losing confidence in the country’s banks just when those banks need to raise billions in new capital to fix portfolios swamped with bad loans.

In other words, consider the possibility that what looks like a sign of strength is actually a loud signal of growing weakness in China’s banking sector.

Hey, it wouldn’t be the first time, would it, that a country had cynically designed a stress test with the purpose of reassuring investors that its banks were safe? The euro and the U.S. stress tests were exactly that kind of exercise, after all.

Think I’m being too cynical? (Can you be too cynical about bank accounting in any of the world’s markets?) Well, look what happened after regulators announced the new test. (The last stress test of China’s banks assumed a 30% worst-case drop in real estate prices. Sure doesn’t look like things are getting better for bank balance sheets, does it?)

On August 5 shares of property developers plunged on the Shanghai stock exchange on news of the new test  and shares of the country’s big banks followed. It was the worst drop for the sectors in three weeks. The market seemed to think that the new worst case scenario in the test was a sign that the government was getting more worried about real estate loans.

On August 6 bank regulators rushed to assure investors that the stress test didn’t mean that at all. The worst-case scenario isn’t a sign that regulators are predicting a 50% to 60% drop in real estate prices or, the China Banking Regulatory Commission said, that regulators are looking to impose even tougher controls on bank lending and mortgages.

Regulators are simply being prudent and regulators will simply continue to instruct banks to “resolutely” curb speculation.

The Shanghai Composite Index climbed 1.4% on the reassurance. Bank regulators, I’d say, have at least one eye on stock prices.

The previous stress test—the one that assumed a 30% worst case drop in real estate prices—showed that banks would take a substantial but manageable hit. Non-performing real estate loans at Chinese banks would, in aggregate, climb by 2.2 percentage points if real estate prices dropped by 30%.  (The damage would be much less at some banks. Bank of China (BACHY), for example, announced that its bad-loan ratio would increase by 1.2 percentage points under the worst-case scenario.)

Those results are one reason that China’s banks were initially told to raise $60 billion in new capital (if you include the Agricultural Bank of China $20 billion initial public offering.) For more on what the bursting of China’s real estate bubble would look like see my post if China were to have a real estate bust, what would it look like?)

But that first stress test may have actually backfired. China’s banks announced plans to raise that $60 billion—and then kept announcing more rights offerings and other moves to raise even more capital. If banks needed just $60 billion what was the extra capital for? investors started to wonder.

The new stress test answers that question. Bank regulators are just forcing banks to be even more conservative. Raising the extra capital is just prudent—even though we all know that the banks won’t really need it.

Especially since government measures to rein in speculation in the real estate market are working. Property prices in 70 cities dropped by 0.1% in June from May, the government announced on July 12. Year-to-year prices rose by 11.4%. And that makes June the second month in a row to show a drop in the rate of increase after a record jump in April.

Which would be great news for China’s banks if residential real estate loans were their biggest problem. Then the government’s moves to limit lending for second and third mortgages, to require bigger down payments and the like would be exactly what the banks needed.

But while there is no doubt that China’s residential real estate market is in the grip of a speculative frenzy, the real danger to China’s banks comes from their portfolios of commercial loans and the loans they’ve made to investment companies affiliated with local governments.

China’s banks lent $1.4 trillion in 2009, more than twice as much as in 2008, as part of the Beijing government’s plan to stimulate the Chinese economy. In the rush to lend, banks extended loans to investment companies affiliated with local governments for projects that don’t have any hope of generating enough cash flow to cover their interest payments. A recent report estimated that a little more than 20% of those loans are likely to go bad.

That’s not the 2.2% bad loan ratio revealed in the first stress test. A 20% bad loan ratio is going to require that either banks come up with lots and lots of capital or that the government bury bad loans in the portfolios of special investment vehicles set up for the specific purpose of taking bad loans off bank balance sheets. That second alternative is the strategy that China pursued after the 1997 Asian currency crisis.

In contrast to 1997 China’s biggest banks are now public companies and face more scrutiny from investors than after the earlier crisis. It will be harder, but not impossible, to move bad loans off bank balance sheets.

It looks to me like China is trying a more complicated strategy this time. Stress tests are designed to reassure investors so that banks can raise capital in the financial markets. And because the potential shortfall of capital is large enough to rattle the financial markets if it all had to raised in that channel, China’s network of state controlled investment companies will feed more capital into the banking system.

Call it an “in plain view” and an “out of view” strategy.

So, for example, according to unidentified sources cited by China Daily, Central Huijin Investment, plans to sell $25 billion in bonds in the next few months. Central Huijin, which owns stakes in China’s biggest banks, will largest channel about half of that to the banks where it will be added to bank capital.

No need to sell stock to investors. No rights offerings to raise complaints among existing investors. And lots of movement of assets, liabilities, and capital from one government-controlled financial entity to another with only very limited transparency.

And with almost no chance for investors or financial analysts to figure out where that new capital is actually coming from. There’s nothing, of course, to prevent state-controlled financial companies from buying bonds from each other with money that, ultimately, comes come an account somewhere in Beijing.

Whatever the new stress test shows China’s banks will be able to raise the capital that they need.

All this is about the short run, however. In the long run those vanity apartment buildings, those empty offices and shopping malls, those highways to nowhere and airports without traffic will have to be paid for out of the future wealth of China.

The country will be a little less rich tomorrow for every yuan it wastes today.

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