'The NPL report did not go through our normal internal review and approval process before it was released to the public and, as it contains errors, we are withdrawing the report. We sincerely regret any misleading views that the report conveyed.' Ernst & Young May 12 A NUMBER CRUNCHER at Ernst & Young has egg on his face because he did not consider political sensitivities when saying last week that non-performing loans (NPLs) in China's banks could hit US$911 billion, almost six times the official figure. I know the feeling. As a junior research analyst during a market downturn years ago, our London office asked me to assign risk ratings to 100 Hong Kong stocks - (A) for no problem, (B) for troubled, (C) for bust. I listed six names as bust. Our London office then told our clients, our clients told competing brokers, the competing brokers told the relevant companies and they in turn complained to my boss. The goods hit the fan when I came in to work the next day. 'How could you be so stupid?' the boss said. 'You ought to know better than to play with fire. Now go and apologise to these people.' Five of those six companies did go bust later but I had learned my lesson. For a long time thereafter I made use of only three recommendations - (A) Buy, (B) Buy on weakness and (C) Long-term Buy. But I think I had a better boss than the Ernst & Young one. Mine insisted on an apology but did not insist that I retract my views. He knew I was probably right. The Ernst & Young apology, however, speaks of 'errors' and 'misleading views'. Are they truly so? The point, and the Ernst & Young apology emphasises it, was that this US$911 billion was 'identified as a potential future amount'. We are talking of what could happen in a cyclical downturn in China and we would be unwise to assume that it cannot happen, although some people seem to think so. Of course, the NPL position is not now this high. Any economy booming along at 10 per cent growth shows, or should show, only a fractional NPL ratio while the boom lasts. In fact, it is surprising that China's official NPL ratio is 8 per cent of total advances, even after government bailouts. This is very high for a boom. Let us do some what-if conjecturing, using the experience of Thai banks in the 1997 collapse as an example. In 1996, the Thai economy had boomed along for 10 years at an average of 9.5 per cent growth. The equivalent figure for China over the past 10 years is 9.1 per cent. Then it all unravelled for Thailand. The red line in the first chart shows you that the banking sector index of the Thai stock market collapsed in August 1998 to only 3.7 per cent of its January 1996 level in US dollar terms. I do not have figures for Thailand's NPL ratio earlier than June 1997 but I am sure it was no higher than 8 per cent of total advances before the collapse got under way. Now take note of two things that the blue line for the Thai NPL ratio shows you. The first is that the real damage was not fully recognised until more than three years after the Thai banking sector index began its slide and the second is that this NPL ratio then rose to 47.4 per cent. But China is no Thailand, you say. It is inconceivable that this could happen in China. Look at the second chart. It shows you that in the six years before the 1997 crash Thailand put more than 40 per cent of its economic effort into fixed capital formation. It was grossly misallocated capital, the result of people investing blindly in the false confidence that the boom was permanent. China, however, shows an even higher capital investment ratio at the moment, all of it with equally compelling evidence that money is being misspent. So here is my what if. Taking only non-financial private sector loans, how much lending would China's banks have in the non-performing category if they were to suffer the same overall NPL ratio that Thailand suffered at the worst of its collapse? Your answer is US$1.23 trillion, even higher than Ernst & Young's retracted estimate. I do not say it will happen. There are reasons why China's experience may be different from Thailand's in a downturn. I do say, however, that Ernst & Young need not apologise so strenuously, aside, of course, from the fact that it is the auditor of one of China's Big Four commercial banks. Political sensitivities, you know.