S&P Global Ratings downgraded China's long-term sovereign credit rating on Thursday, less than a month ahead of one of the country's most sensitive political gatherings, citing increasing risks from its rapid build-up of debt.
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-fueled stimulus needed 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 that there was a "real" chance of a downgrade and that 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 6-6.5 percent, or not have one at all. That would be a positive sign."
The International Monetary Fund warned earlier 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 signaling a banking crisis in the next three years.
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 were already closed Thursday when the downgrade was published, and there was little reaction in the yuan.
While risks are rising, S&P said that recent efforts by the government to reduce corporate leverage could stabilize 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.
MIXED PROGRESS SO FAR
Analysts say China's campaign to reduce financial risks this year has had mixed success so far, and opinions differ widely on whether Beijing is moving quickly 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 outpace 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 Millenium Global Investments in London.
"One element that models cannot capture is the strength of institutions such as transparency of regulation of the banking sector and central bank independence. All that is an argument to say China's rating might still be too good.”
(By Elias Glenn; Additional reporting by Bangalore newsroom, and John Ruwitch and Winni Zhou in Shanghai; Editing by Kim Coghill)