Ratings agency Fitch on Tuesday downgraded its outlook on China's local currency debt rating from "stable" to "negative" as on concerns over a huge rise in potentially destabilising easy credit.
Fitch's rating for China's yuan-denominated debt rating currently stands at "AA-", four notches below its top classification.
Fitch's decision implies that it could, in the medium-term, decide to downgrade the rating of the local currency debt of the second largest economy in the world.
That is despite the fact that China holds the world's largest stock of foreign currency reserves, some $2.8 trillion at the end of 2010, according to Fitch, which makes it almost invulnerable to external shocks.
However, the ratings agency argued that "elevated credit growth, the sharp rise in real estate valuations, and more recently the emergence of inflation pressures have ... increased the risks to macro-financial stability."
Added to this scenario is the increased scale of sovereign contingent liabilities "arising from the banking sector and local governments."
The negative outlook "reflects concern over the scale of sovereign contingent liabilities and risk to macro-financial stability arising from the very rapid pace of bank lending in recent years, especially against the backdrop of rising real estate valuations and inflation," said Andrew Colquhoun, Head of Fitch's Asia-Pacific Sovereigns group.
"Fitch expects some sovereign support for the banking system will be required. Although the timing and size are difficult to predict," he added.
The ratings agency predicts a rise in bad debts in China over the next three years after unprecedented growth in recent years which took private-sector credit to around 140 per cent of GDP last year.
"Concerns over the quality of much of that lending are compounded by the rapid increase in new 'off-balance' sheet channels of credit, for which disclosure is extremely poor," it said.
Fitch said it "sees a high likelihood of a significant deterioration in asset quality in the Chinese banking system in the next three years ... a rise in the non-performing loan (NPL) ratio to 15-30 per cent could necessitate upwards of 10-30 per cent of GDP in support for the system," it warned.
While the headline non-performing loan ratio stood at just 1.1 per cent at the end of last year, "a more conservative classification" would put that figure at 6.0 per cent already, it said.
That level nearly exhausts the agency's "estimate of the banks' own loss-absorption capacity," it added.