The Government has one overriding priority in this downturn. Plunging property prices, rising unemployment and painful bankruptcies can be tolerated, just so long as they do not threaten the banking system. The question is how much pain can the economy take before stress translates into a banking crisis? So far, the signs are encouraging. Since the October attack on the currency, improved liquidity has dramatically lowered interest rates. For sure, banks face harsh funding conditions, but with short-term rates close to US levels, their worry now is crushed margins. Paying up to 9 per cent for three-month deposits leaves no fat to repair balance sheets but beats the grim January conditions. Hong Kong faces the pain of contraction. Property prices have yet to bottom, retail sales are anaemic and unemployment is rising. Rather than a dramatic collapse banks must deal with worsening asset quality and reduced margins - the next year will, at best, be one of attrition. A recent Morgan Stanley report outlined the role of big local banks in averting corporate failures. Forced asset disposals and moratoriums on paying foreign banks have kept the wolves from the door, it argued. Can it continue? Certainly the likes of Hongkong Bank have a huge interest in boosting sentiment and supporting big firms, but if market conditions deteriorate bankruptcies are inevitable. Across town, money is extremely tight. Despite wielding administrative pressure not to close down embattled firms, Hongkong Bank did not increase lending in the first four months of the year. The sharply increased clearing balance of the banking system - $17 billion by April 24 - indicates a credit crunch. The aggressive lending of 1996 and the first half of last year is worsening matters. With many loans made at just 25 basis points over the prime rate, banks must bid strongly for deposits to fund their existing loan books. This will squeeze profits at a time when non-performing loans are rising sharply. So far, small corporate defaults, trade finance and stock-related lending account for most bad debts. Dresdner Kleinwort Benson points out that what has been reported represents the tip of the iceberg and swelling litigation to recover debts offers a leading indicator of what is to come. Interestingly, the High Court writs list is dominated by Bank of China group of banks seeking legal recourse. Whether this is the result of lax lending policies, exposure to the red-chip boom and bust, or simply an aggressive effort by the BOC to clean up its balance sheet is not clear. What is certain is that lending by foreign banks has dramatically reduced. This has been most marked among Japanese banks, which have rushed to protect their capital adequacy ratios by closing exposure to non-yen loans and stopping new advances. Dresdner Kleinwort Benson reckons the trend is structural, with liberalised banking conditions in Japan reducing the need to book loans through Hong Kong. Given the size of the offshore Japanese lending market, as much as 1 per cent might be sliced off Hong Kong's gross domestic product, it argues. Such are the intangible losses that Hong Kong faces as Asia's premier financial centre when most of its neighbours are practically bust. While clean-up professionals are pouring in to package and sell what assets can be scavenged, the lost income from international banking alone is likely to be far greater. All this means fewer commercial bankers, credit analysts and support staff. In short, traditional highly paid white collar professionals - probably with a hefty mortgage - out of a job. For local banks depending on home mortgages as their highest quality asset, such a spiral means higher provisioning. Such is the nature of economic downturns. The worry in Hong Kong is the sheer scale of outstanding credit. At 165 per cent of GDP, it is huge. The dependence on foreign bank lending with Hong Kong dollar loans exceeding deposits by 12 per cent only heightens our vulnerability. It is what keeps government officials awake at night.