Fitch Ratings warned on Thursday that it might downgrade China's credit rating within two years as the country's banks struggle with debt loads following a lending surge to help lift the economy during the 2008 financial crisis.

It also said that Japan, weighed down by a public debt load twice the size of the $5 trillion economy, faced a greater-than-even chance of a downgrade in part due to a political impasse that is stalling plans to clean up its finances.

Asia's two biggest economies are in the ratings firing line alongside Europe and the United States as they deal with massive debts built up during the global financial crisis.

Andrew Colquhoun, head of Asia-Pacific sovereign ratings at Fitch, told Reuters in an interview that China's local currency debt rating could be downgraded over the next 12 to 24 months.

"We expect a material deterioration in bank asset quality," he said. "If the problems in the banking system pan out as we expect or are even worse over the next 12 to 24 months, then that would incline us to take the rating downwards."

Fitch downgraded the outlook on China's long-term local currency debt to negative from stable in April because of concerns about the country's financial stability following a lending surge encouraged by Beijing to help maintain economic growth during the global downturn.

Fitch's China long-term local currency rating is AA minus, its fourth highest level, on a par with Italy and a notch below Spain, Reuters data shows.

Fitch has sounded the loudest warnings of the three main ratings agencies about the surge in lending in China and is the only one with a negative outlook on the long-term local currency debt rating.

China reported local government debt of 10.7 trillion yuan ($1.67 trillion) as of the end of 2010. More than 347 billion yuan in urban construction investment bonds were issued in the five years to 2010.

Last month, China's top banking regulator Liu Mingkang said work to clean up local government debt was progressing smoothly, the latest comment from officials to try to reassure skeptical capital markets that risks were manageable.

Colquhoun said non-performing loans at Chinese banks were about 2 percent of the total, but if lending to local government financing vehicles was appropriately classified, the figure would be more like 6-7 per cent.

"That by itself is sufficient to exhaust the banks' internal absorption capacity," he said. "So any further deterioration in asset quality beyond that... would lead to a requirement for sovereign support, which then affects the sovereign credit profile."

While in general terms it was known how much stimulus during the financial crisis cost European countries and the US, Colquhoun said, because in China it was done through the banking system, "in a nutshell we don't know how much it cost."

"We haven't seen the full cost come through yet."

Further Deterioration?

There was a risk that asset quality could deteriorate further because bank lending was still running at a fast pace, Jonathan Lee, Fitch's senior director of financial institutions, said at a later media briefing.

Lee said Fitch estimated bank loans would increase this year alone by 18 trillion yuan.

"This is the equivalent to 55 per cent of China's GDP, which is an extremely high number and a potential problem for banks' asset quality," he said.

Japan's credit rating has already been cut this year by Fitch's rivals, Standard & Poor's and Moody's. Like Fitch, they cite the inability if Japan's leadership to come up with a plan to reduce the debt load over time.

"We think the ratings on current trends are more likely than not to go down," Colquhoun said. "To shore ratings up at their current level we need to see a credible fiscal consolidation plan."

The three major agencies rank Japan's credit ratings at their fourth highest levels. However, both Fitch and S&P have a negative outlook, suggesting further rating downgrades unless Japan is able to come up with a credible plan to sort out the debt.

"Our confidence that we will see it is not high because of the track record of the politics," Colquhoun said.

Japan's government spokesman declined to comment.

Hopes now rest on Yoshihiko Noda, appointed last week as Japan's sixth prime minister in five years, to forge a political consensus in the divided parliament, or Diet. The costs of reconstruction following the March 11 earthquake and tsunami and the recession it triggered is adding to Japan's debt burden.

"We'll see if Mr Noda has the formula to break the logjam in the Diet. But if we don't, then the ratings will be coming down."

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