Moody's Investors Services downgraded China's long-term local and foreign currency issuer ratings on Wednesday, citing expectations that the financial strength of the world's second biggest economy would erode in the coming years.
The ratings agency also changed its outlook for China to stable from negative.
The downgrade by one notch to an A1 rating from Aa3 comes at a time when the Chinese government is grappling with the challenges of slowing economic growth and rising financial risks stemming from soaring debt.
"The downgrade reflects Moody's expectation that China's financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows," Moody's said in a statement.
"While 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 the consequent increase in contingent liabilities for the government," it said.
While the downgrade is likely to modestly increase the cost of borrowing for the Chinese government and its state-owned enterprises, it remains comfortably within the investment grade rating range.
China's yuan currency in the offshore market dipped nearly 0.1% against the U.S. dollar after the ratings agency announced its decision. But the loss was soon reversed and the offshore yuan rebounded to 6.8845.
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In March 2016, Moody's changed its outlook on China's government credit ratings to negative from stable, citing rising debt and uncertainty about the authorities' ability to carry out reforms and address economic imbalances. Rival ratings agency Standard & Poor's cut its outlook to negative in the same month. Its AA- rating is one notch above both Moody's and Fitch Ratings' A+ rating.
Moody's said its now stable outlook reflected the assessment that risks were balanced.
"Moody's expects that economy-wide leverage will increase further over the coming years," it said, adding that China's reform program is likely to slow, but not prevent, the rise in leverage.
Meanwhile, China's potential GDP growth is likely to slow towards 5% in the coming years, but the slowdown is likely to be gradual due to expected fiscal stimulus, it said.
Moody's said it expects the government's direct debt burden to rise gradually towards 40% of GDP by 2018 "and closer to 45% by the end of the decade".
Economy-wide debt of the government, households and non-financial corporates would also continue to rise, it said.
"Taken together, we expect direct government, indirect and economy-wide debt to continue to rise, signalling an erosion of China's credit profile which is best reflected now in an A1 rating," it said.