Ernst & Young's retracted report re nonperforming loans

A muffled report
http://www.economist.com/finance/displaystory.cfm?story_id=E1_GJVVVTV

May 18th 2006 | HONG KONG
From The Economist print edition
An attempt to estimate China's bad loans backfires

ALTHOUGH China likes most of its numbers to be big, it has been trying to reduce one of them: the size of the bad loans burdening its banks. A report this month by Ernst & Young, a big auditing and consulting firm, therefore came as quite a shock. Ernst & Young, which does plenty of work on the mainland, claimed that China's stock of non-performing loans (NPLs) added up to $911 billion. This is more than five-and-a-half times the latest government estimate of $164 billion, published in March. The report deemed the country's big four state-owned banks, which are trying to attract international investors, to be carrying $358 billion of bad loans, almost three times the official tally.

The People's Bank of China, the country's central bank, quickly attacked the research as “ridiculous and barely understandable�. This week an embarrassed Ernst & Young withdrew it, admitting that it was “factually erroneous� and that it had somehow slipped through the firm's normal checks. Ernst & Young says it plans to publish a revised version in due course.

The authorities' savage reaction is easy to understand. Other commentators and consultants have published estimates of China's NPLs ranging from $300 billion to $500 billion without attracting similar condemnation. Ernst & Young's estimate stood out not only for its size but also for its timing. The central bank's rebuttal came on the very day that Bank of China, the second of the big four to attempt a stockmarket listing in Hong Kong, began its investor roadshow. Bank of China plans to raise $9.9 billion, even more than the $9.2 billion pulled in by China Construction Bank, which was floated last October. A third big bank, Industrial and Commercial Bank of China, hopes for $10 billion in September. Awkwardly, Ernst & Young is this institution's auditor—and as such had subscribed to the official, much lower estimate of bad loans.

Even so, the firm's categorical withdrawal of its research looks like an overreaction. The report was more than a compilation of historic bad debts; drawing on work by other organisations, it also made a stab at estimating the new NPLs that will result from a lending spree between 2002 and 2004. These account for most of the difference between Ernst & Young's figures and the official ones. And they are particularly relevant now that the mainland is in the midst of another credit surge: new loans in April amounted to 317 billion yuan ($40 billion), more than twice as much as in the same month last year. Although China has made progress in shifting bad loans off the banks' balance sheets, there is little sign that the banks themselves have fundamentally changed their behaviour and become rational lenders.

Neither side emerges with much credit from this episode. Ernst & Young seems to have caved in too quickly to Chinese demands, at a cost to the perceived independence that it needs to win respect and clients. The Chinese authorities, meanwhile, look like bullies. Bad loans are almost certainly greater than the official numbers say, even if they are less than Ernst & Young's estimate. To deny this is naive and damages the credibility needed to sell NPLs and shares in its banks to foreign investors. These, indeed, may turn out to be the only winners, if the tale reminds them of the real state of Chinese banks as another one passes round the hat.