????Credit quality in China has once again been making (or at least trying to make) headline news. The latest unconfirmed speculation out of mainland China is that the central government is preparing to shift 2 trillion to 3 trillion yuan of recently-extended debt off of local government balance sheets. The amount, equivalent to $309-$463 billion, is roughly 14%-21% of the total outstanding debt of China's local government financing vehicles (LGFVs) according to the People's Bank of China's 2010 Regional Financial Operations Report.

????At an amount roughly equivalent to 5.2%-7.9% of China's GDP, it's clear to us that this bailout of sorts is a big deal. To put some context around the size of this rumored bailout package, TARP was "only" 4.9% of US GDP at the time of passage. Whether or not this winds up being "it" as it relates to financial crisis aversion in China remains to be seen.

????One thing that is quite disconcerting is the strong denial of any bailout by Chinese officials. Wu Xiaoling, vice chairman of the National People's Congress Financial Committee dismissed the rumors, saying that they had been confused with a telegraphed government investigation into LGFVs during the June-September period. As we have learned from the likes of Greece, Ireland, and the U.S. for that matter, politicians' denials of market rumors are typically anything but a sign of relief.

????That said, we are in the unique position of waiting for more data before we jump ship on our "Year of the Chinese bull" thesis. We've chosen to remain on the sidelines here, rather than expressing this idea in our virtual portfolio due to China-specific quantitative factors and broader global macro factors. Separating research ideas from actual investments remains one of the hallmarks of modern-day risk management, as well as one of the best ways to practice Warren Buffett's rule #1: don't lose money.

????Shifting back to the Chinese bailout rumor specifically, let's dig into the background story and relevant components in an effort to get you up to speed.

????In an unprecedented effort to avert a sharp recession for the Chinese economy, the central government via Chinese financial institutions oversaw a 17.6 trillion yuan ($2.7 trillion) expansion of credit from 2009-2010. During the rapid debt buildup, money supply (M2) growth peaked at 29.7% year-over-year growth in November '09. It has since come down to more trend-line levels as the central bank ramped up its efforts to drain liquidity and curb property speculation over the last 18 months via increases in bank reserve requirements, as well as four interest rate hikes since October '10 totaling one percentage point.

????On Tuesday, the PBOC raised capital requirements for the sixth time this year after inflation rate rose to 5.5% -- much higher than expected.

????A great deal of the credit expansion over the last two years had been funneled through the aforementioned LGFVs. Current statutes in China prevent local governments from issuing debt to finance spending and investment -- as a result, they have setup alternate arms-length entities through which debt financing is procured. It can be strongly argued that their obligation to implement the central government's stimulus objectives over the last couple of years is perhaps what got them into the current situation. Moreover, as the Jim Chanos-es of the world would have you believe, rapid and perhaps reckless credit expansion is not without consequence.

????According to the PBOC's recent report, the total number of LGFVs grew by 25% from 2008-2010 to over 10,000 and their collective debt burdens grew by 50% in 2009 and 20% in 2010 to an estimated sum of 14 trillion yuan ($2.2 trillion) or 28% of total credit outstanding throughout the Chinese banking system as of April. Additionally, Premier Wen Jiabao's push to build 36 million low-income housing units is estimated by some analysts to add another 1.9 trillion yuan ($296 billion) to the existing LGFV debt burden in this year alone and another 4.9 trillion yuan ($757 billion) through 2015.

????Further, the PBOC profiles these loans as "mostly long term" and "linked to infrastructure projects" with about half of them coming due in 2014-15. An unverified leak from an unnamed Chinese official suggests that roughly 20% of the total LGFV debt burden would ultimately wind up in the non-performing loan category; Fitch Ratings assigns a 30% non-performing loan ratio in their worst-case scenario.

????Using the aforementioned 20% or 30% NPL rate, that roughly equates to the Chinese banks having to charge-off 5.6%-8.4% of their total loan books over the long term, with roughly half of that occurring in the next 3-4 years based on the maturity schedule of the aggregate LGFV debt burden. That's a pretty substantial amount of bad loans that will likely have to incrementally reserved for – which is perhaps why Chinese banks have been substantially underperforming the broader index of late.

????Last year, Chinese banks sold a combined $70 billion of shares in a comprehensive effort which included cutting dividend payout ratios (an average of -200bps to 37% for the five largest banks) and expanding non-lending businesses to become compliant with higher capital requirements. Back in April, China's banking regulator drafted rules forcing banks to have Tier 1 capital ratios of at least 8.5% by 2016; for reference, the nation's lenders had an average Tier 1 capital ratio of 10.1% according to the same documents (that compares to an average of 12.3% of the world's top 100 largest banks by market cap, per Bloomberg). Still, the rules assume average credit expansion to the tune of +15% year-over-year alongside economic growth of +8% per year, which implies Chinese banks are likely to have to add another 1.26 trillion yuan ($195 billion) in supplementary capital over the next five years.

????From a more immediate perspective, the same regulator has forced the nation's five largest banks (combined holders of 26.8 trillion yuan of risk-weighted assets) to adhere to a minimum capital adequacy ratio of 11.5% throughout 2011. Should any of them fall below that threshold for any moment of time, they'll be forced to raise capital, slow loan growth, delay acquisitions, and/or suspend new branch openings to become compliant in 90 days. Each of the banks is well capitalized above the recently-implemented floor, but still well below the average capital adequacy ratio of the world's 100 largest banks by market capitalization, per Bloomberg.