S&P downgrades China, says rising debt is stoking economic, financial risks

S&P's one-notch downgrade to A+ from AA- comes as Beijing grapples with the challenges of containing financial risks stemming from years of credit-fuelled stimulus to meet ambitious government economic growth targets.

"The downgrade reflects our assessment that a prolonged period of strong credit growth has increased China's economic and financial risks," S&P said in a statement, adding that the ratings outlook was stable.

S&P had said in June there was a "real" chance of a downgrade and a decision would be made based on whether China is able to move away from a credit-driven growth strategy. The demotion follows a similar move by Moody's Investors Service in May.

While S&P's move put its China ratings on par with those of Moody's and Fitch, the timing raised eyebrows just weeks ahead of a twice-a-decade Communist Party Congress (CPC), which will see a key leadership reshuffle and the setting of policy priorities for the next five years.

"The downgrade is a timely reminder for the authorities that China needs to bite the bullet on some of the more painful reforms that have been left to last, namely corporate deleveraging and restructuring of state-owned companies," said Rob Subbaraman, an economist at Nomura in Singapore.

"The focus needs to shift from quantity to quality of growth. I hope that later this year China lowers its GDP growth target to 6 percent to 6.5 percent, or not have one at all. That would be a positive sign."

The International Monetary Fund warned this year that China's credit growth was on a "dangerous trajectory" and called for "decisive action", while the Bank for International Settlements said last September that excessive credit growth was signalling a banking crisis in the next three years.

The IMF said in August it expected China's total non-financial sector debt to rise to almost 300 percent by 2022, up from 242 percent last year.

While worries about China's sustained strong credit growth are increasing in some quarters, first-half economic growth of 6.9 percent beat expectations and some analysts said the downgrade would have little impact on financial markets.

"The decision was a catch-up with the other two credit agencies, instead of an initiative. Its impact on financial markets would very limited," said Ken Cheung, senior Asian FX strategist at Mizuho Bank in Hong Kong.

"For those invested in yuan-denominated bonds, they care more about yuan expectations. The downgrade decision is likely to have limited impact on capital inflows as well."

China's stock markets had closed Thursday before the downgrade, and there was little reaction in the yuan currency.

While risks are rising, S&P said the government's recent efforts to reduce corporate leverage could stabilise conditions in the medium term.

"However, we foresee that credit growth in the next two to three years will remain at levels that will increase financial risks gradually," S&P said.

S&P also lowered China's short-term rating to A-1 from A-1+.

"It is in recognition of the reality that, concerns notwithstanding, the authorities are not planning to rein in credit growth in a forceful way," said Louis Kuijs at Oxford Economics in Hong Kong.

Indeed, Chinese banks kept the taps open in August, handing out 1.09 trillion yuan ($165.40 billion), and the growth of outstanding loans was higher than expected, at 13.2 percent.

MIXED PROGRESS

Analysts say China's campaign to cut financial risks this year has had mixed success, and opinions differ widely on whether Beijing is moving fast enough, or decisively enough, to avert the risk of a debt crisis down the road.

Regulators are making significant inroads in reducing interbank borrowing – perhaps the most pressing risk - and have curbed some riskier types of shadow banking.

But analysts agree more comprehensive structural reforms are needed. Though the pace of credit growth may be easing, new bank lending and total social financing may hit fresh records this year and continue to outstrip economic growth.

A recent Reuters analysis showed corporate debt is growing faster than last year, with few companies using stronger profits to reduce debt.

"China's credit problem is the biggest problem we have ever seen in any country and probably justifies a lower rating," said Claire Dissaux, head of global economics and strategy at Millennium Global Investments in London.