Chinese banks face growing risks as they are heavily exposed to the "shadow banking" being used by debt-laden local governments to raise funds, global ratings agency Fitch said on Wednesday.
Fitch's warning over the health of China's banking sector came a day after its cut of China's long-term local currency debt rating by a notch to A-plus.
"The banking sector is "significantly exposed" to the shadow banking because there all sorts of ties between the banks and shadow credit channels," Charlene Chu, head of China financial institutions at the ratings agency, told a teleconference.
Chu said a lot of "shadow credit" was going to many sectors, which included local governments.
Total shadow financing in China could amount to around 60 percent of gross domestic product (GDP) and some 80 percent of new funds could be linked to commercial banks, Chu estimated.
The sprawling shadow financing, which includes trust loans, bank acceptance bills and underground lending, has driven the torrid rise in overall credit, which is approaching 200 percent of GDP, Fitch said.
Many local governments, facing difficulties in getting fresh bank credit, are turning to the so-called shadow financing channels to fund investment projects, Chu said.
"We could see an asset quality problem in the financial sector in fairly sizable magnitude within the next few years," Chu said without elaborating.
Ratings agency S&P estimates that outstanding Chinese shadow banking credit totaled $3.7 trillion by the end of 2012, equal to 34 percent of on-balance-sheet loans and 44 percent of GDP.
China's banking regulator said the bad bank loan ratio was 0.95 percent at the end of 2012, down 0.05 percentage points from a year earlier. But that figure only covers on-balance-sheet loans, leaving a huge amount unmonitored.
"All Chinese banking is an arm of the government but that doesn't stop loans going sour, it only stops them showing up as sour," said Gary Greenberg, Hermes Fund Managers Head of Emerging Market Equity.
"There is a maturity mismatch in the financial system: long term infrastructure lending versus short term bank funding."
Chinese banks have rushed to sell short-term wealth management products to support their credit growth.
Chinese regulators have shown greater concerns over risks from off balance-sheet banking activity, but they face a dilemma as banks embrace financial innovations under Beijing's strategy to gradually liberalize financial markets and interest rates.
The proportion of bank loans in the total social financing - a broader measure of liquidity in the economy that covers bank loans as well as alternative financing - has fallen to a record low of 52 percent in 2012 from over 90 percent a decade ago.
Fitch estimated that local government debt may have climbed to 12.85 trillion yuan ($2.1 trillion) at the end of 2012, or about 25 percent of GDP, up from 23.4 percent at end-2011.
Official data showed that local governments had amassed debt of 10.7 trillion yuan by the end of 2010. The government has yet to update the figures.
Beijing is trying rein in the debt build-up - a hangover from Beijing's 4 trillion yuan stimulus package launched at the height of the global crisis in 2008 to underpin the economy.
Few analysts expect widespread debt defaults by local governments given China's healthy economic growth, and Beijing has deep enough pockets to step in if needed, analysts say.
"China's broad debt problem ultimately is going to need sovereign resources to fix in some way," said Andrew Colquhoun, Fitch's Head of Asia-Pacific Sovereigns.
Fitch said it will keep China's local and foreign currency credit ratings on a stable outlook in the foreseeable future.
($1 = 6.2024 Chinese yuan)
(Additional reporting by Umesh Desai in Hong Kong; Editing by Simon Cameron-Moore)