Fitch Lowers Rating on China Local-Currency Debt in one of the most prominent warnings to date over a credit buildup in the world’s second-largest economy

Updated April 9, 2013, 9:26 a.m. ET

Fitch Lowers Rating on China Local-Currency Debt

By AARON BACK

BEIJING—Fitch Ratings Inc. on Tuesday lowered one of its key ratings on China’s government debt, in one of the most prominent warnings to date over a credit buildup in the world’s second-largest economy.

The downgrade applies only to China’s yuan-denominated debt, which is primarily traded domestically—not the foreign-currency debt that it issues in international financial markets, so it is unlikely to have a big impact on global financial markets.

But the move highlights a risk to the Chinese economy that has been flagged recently by analysts and market players: that massive lending by China’s banks, as well as shadowy nonbank institutions, runs the risk of turning bad.

The credit rating agency lowered China’s long-term local currency rating to A+ from AA-, with a stable outlook. It kept China’s foreign-currency rating unchanged at A+, saying it is well supported by China’s massive foreign-exchange reserves, worth $3.387 trillion at the end of 2012.

“Risks over China’s financial stability have grown,” Fitch said in a statement. The stock of bank credit extended to the private sector was worth 135.7% of China’s gross domestic product at the end of 2012, the highest level of any emerging market economy rated by Fitch, it said.The buildup in debt has raised alarm bells among some economists who note that other nations have seen credit binges turn into economic busts. “The speed of credit growth concerns me,” said UBS economist Wang Tao. “Any time credit is growing so fast, it makes people worry about misallocation and bad debt.”

China’s biggest banks are all state-controlled and enjoy implicit state backing, so if they come under pressure from loans turning bad, the ultimate costs will come to fall on the central government.

China’s debt load is rising even faster when forms of what is known as shadow banking are included. That includes lending by nonbank institutions such as trusts, which are lightly regulated investment companies. It also includes forms of bank credit that are kept off official balance sheets.

Total credit including various forms of shadow-banking lending may have reached 198% of GDP, Fitch estimated.

“The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial-stability perspective,” Fitch said.

One major driver of this off-balance-sheet finance has been the issuance of wealth-management products by banks, a form of high-yield investments marketed to individuals, with the proceeds either lent out or plowed into stocks or bonds.

Fitch estimated earlier that the total amount of outstanding wealth-management products was around 13 trillion yuan ($2.08 trillion) at the end of last year—equal to about 14.5% of total banking-system deposits—compared with 8.5 trillion yuan at the end of 2011.

Last month China’s banking regulator issued new regulations on wealth-management products, instructing banks to reveal how the proceeds are invested and limiting the amount that can be invested in opaque assets that aren’t publicly traded.

At a forum in China on Monday, billionaire financier George Soros also raised concerns over China’s shadow-banking sector.

“One could see the beginnings of a hard landing last year when the authorities ordered the banks to cut back on lending,” he said, a move that prompted many borrowers to turn to nonbank sources of credit, where they pay higher interest rates.

“Some borrowers, particularly in the housing industry, were willing to pay much higher interest rates even as their profits were under pressure. This raised the risk that the loans would eventually default,” Mr. Soros said.

“Most of these loans came from the wealth-management and other subsidiaries of commercial banks. Wealth-management products are not legally guaranteed by the parent but so far the parent company always paid up on the few occasions when there was a shortfall,” he added.

Still, not all analysts see immediate risks from the debt buildup. “We do see risks of rapid financial innovations and deregulation, but to predict an imminent financial crisis seems to be an exaggeration,” Bank of America-Merrill Lynch economist Lu Ting said in a note.

“Further improvement in regulations and structural reforms could prevent current problems from morphing into systemic risks in China, in our view,” Mr. Lu added.

Besides the costs it may ultimately have to bear to support domestic banks, Beijing is also officially on the hook for the debt run-up by China’s local governments. The finances of local governments are murky, making it difficult to judge the extent of outstanding debt.

Fitch, in its statement on Tuesday, estimated that China’s local government debt rose to 12.85 trillion yuan, or 25.1% of GDP in 2012, up from 23.4% in 2011. That brings the total level of government debt to 49.2% of GDP, Fitch said, around average for countries rated in the A-range.

Others see even higher figures. Last week, former Chinese Finance Minister Xiang Huaicheng said local government debt could exceed 20 trillion yuan, though he still voiced confidence that the problem is manageable.

“Local-government debt lacks transparency, but the overall debt ratio is not very high,” Mr. Xiang said.

Analysts at Fitch have been consistently sounding alarms about China’s debt problems. In May 2012, Fitch warned that it was likely to downgrade China’s credit rating in the next 12 to 18 months.

Fitch has held a negative outlook, which implied a downgrade was likely, on China’s local currency debt since April 2011. It reiterated that view last year, saying that Chinese authorities had already begun to move some of the debt from struggling local governments to the central government’s balance sheet.