Fitch cut China's long-term local currency rating Tuesday to A+ from AA-, bringing it in line with the country's foreign debt rating. The ratings downgrade applies only to debts denominated in yuan.
The ratings agency said it issued the rare downgrade because of three factors: Structural weaknesses in China's economy, an expansion of easy credit and the rise of an opaque shadow banking system.
The problems are related.
In response to the global financial crisis in 2008, China moved to stimulate its economy by increasing the amount of available credit.
Banks and other lenders responded, with credit in China growing since 2009 at a quicker pace than gross domestic product. Only one country -- Qatar -- was issuing credit at a faster rate.
By the end of 2012, credit issued by Chinese banks to the private sector reached 136% of GDP, the third-highest level of any emerging market country rated by Fitch.
Much of the credit was issued to local governments, and used to finance infrastructure projects that helped China sustain rapid economic growth in the wake of the financial crisis.
But local government finances in China are notoriously opaque, and financial partnerships with local businesses are particularly murky. Fitch reckons that local government debt levels are now so high that Beijing will, at some point, be forced to assume some of the burden.
At the same time, more and more credit in China is being issued by non-bank lenders.
Fitch estimates the size of the shadow banking sector has now reached 60% of GDP. While very little data is available, many analysts are worried because shadow lenders are thought to be dealing primarily with unworthy borrowers. If economic growth falters, the lenders could face default.
"We've got small non-banks, without a whole lot of loss-absorption capacity, extending credit to the weakest borrowers," Charlene Chu, head of China financial institutions at Fitch, said Wednesday.
"There is so little transparency over where the money is going," she said.
Beijing has tried to get a handle on credit issuance in recent years, moving to cool the housing market and cut back on local government debt. But when combined with low wages, Fitch said the persistent nature of the trends has created growing risks for China's financial stability.
Still, there are factors that could lead to a positive ratings outlook for China.
Most analysts, as well as the Chinese government, recognize that China needs to move toward an economy in which consumption drives growth.
Fitch said "growing evidence" of a successful rebalancing could lead to a positive ratings action. The country's case could be strengthened, the agency said, if China improved the transparency of its data -- especially at the local level.
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