Moody’s Investor Service has downgraded China’s sovereign credit rating by one notch from Aa3 to A1, citing expectation that China’s financial strength will erode due to rising economy-wide debt. The rating agency has however changed the outlook to stable from negative, it said in a statement on Wednesday.

Though the ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt and a consequent increase in contingent liabilities for the government, said Moody’s.

Screenshot from Moody's website

China’s Ministry of Finance said the credit downgrade was based on “inappropriate methodology”, exaggerated risks facing the Chinese economy, and underestimated the Chinese government’s ability to deepen supply-side structural reform and appropriately expand aggregate demand.

In its statement, Moody’s estimated that the government’s debt burden would increase toward 40 percent of GDP by 2018 and 45 percent by the end of the decade, although the government budget deficit in 2016 was “moderate” at about 3 percent of GDP.

Explaining the change in the country’s ratings outlook to stable from negative, Moody’s said that the move reflects that “risks are balanced.” 

The government's high degree of control over the economy, the financial system and cross-border capital flows offers China the ability to maintain stability in the near term, it added.

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The offshore renminbi has dipped as much as 0.1 percent on the news of the rating cut, and the US dollar has gone up at 6.8940 against it as a result.

The foreign exchange market reacted strongly to the news, with the Australian dollar dropping from levels around 0.7480 US dollars to as low as 0.7452 US dollars in the wake of the Moody’s announcement. China is among the country’s largest export markets.

Liu Dongliang, a senior analyst with China Merchants Bank, said that Moody’s ratings cut has a rather limited impact on Chinese offshore companies’ bonds. Since most of the bondholders are Chinese investors, they have a better understanding of Chinese enterprises’ credit conditions, Liu said.

Moody’s Investor Service is one of the "Big Three" credit rating agencies together with Standard & Poors and Fitch Ratings.