Credit downgrades can elicit fascinating reactions. Take a January move by Standard & Poor’s to cut Japan’s rating to the same level as that of China. I expected the backlash to come from Tokyo, but instead it was the Chinese who were aghast.

Every Chinese official I’ve met since is bewildered that 10 percent growth and $3 trillion (R20.2 trillion) of currency reserves don’t buy a better grade than the AA- China shares with an overly indebted, aging nation that names a new prime minister every year. Many in China even think their economy deserves a higher score than the US, with its AAA rating.

These views are wrong. Credit risks are rising as China battles a worsening inflation threat, the result of which will be slower growth. The process poses bigger risks to China’s creditworthiness and the world economy than investors may realise.

In recent years, economists voiced a similar refrain: only when growth cools will we know the true cost of China’s 2008 efforts to ride out the global crisis.

Somehow, the official price tag, 4 trillion yuan (R4.15 trillion), never satisfied sceptics who didn’t think it possible for China to navigate the meltdown in credit markets with the ease it did.

The secret to China’s success? A huge, unreported accumulation of debt.

Scattered around China are 20 cities that want international airports, glistening skyscrapers, five-star hotels, six-lane highways, world-class universities and ample housing. It is the largest urbanisation in modern history.

This building boom is taking place largely beyond the control of Beijing and financed with easy credit and local debt issuance. The surge of bank loans to local authorities may spark a wave of bank failures that hobbles economic growth.

The jump in local debt increases the risk of default around the nation and leaves Beijing with a touchy question: must it bail out local governments that went too far?

Cities and provinces can’t borrow directly from banks, so they have set up more than 8 000 investment firms to skirt regulations. Fitch Ratings predicts that, from lending to these vehicles, bad loans might reach 30 percent at China’s banks.

That’s not all. One of China’s post-crisis revival plans calls for building 36 million low-cost homes by 2015, an initiative that would add 2 trillion yuan to local government borrowing by 2012.

Expect a huge effort to push liabilities off balance sheets, Enron-style, as bankers scramble to mask the extent of their lending to local governments. It’s these kinds of financial shenanigans that have hedge fund managers like Jim Chanos of Kynikos Associates betting against China.

It’s hard to envision a full-blown crash. China has the world’s biggest pile of currency reserves at its disposal and a command-economy model that gets things done. And the country has been here before. In the late 1990s, years of state-directed credit left lenders saddled with bad loans. The government ended up spending more than $650 billion on bailouts.

This time, the stakes are higher.

Bad debt is inevitable for China; most developing nations get in trouble with it at some point. The question is the dimension: will it merely be a challenge for the government or ruinous for the entire nation?

No economy grows in a straight line forever. As China applies the brakes it could trigger some chain reactions around the globe, not necessarily for the better.

William Pesek is a Bloomberg columnist.