China has strongly criticized Moody's decision, saying it was based on inappropriate methodology.
China’s structural reforms will not be enough to arrest its rising debt, and another credit rating downgrade for the country is possible unless it gets its ballooning credit in check, two officials at Moody’s ratings agency said on Friday.
The comments came days after Moody’s Investors Service downgraded China’s sovereign ratings on Wednesday by one notch to A1, saying it expects the financial strength of the world’s second-largest economy will erode in coming years as growth slows and debt continues to rise.
China has strongly criticized Moody’s decision, saying it was based on inappropriate methodology, exaggerating difficulties facing the economy and underestimating the government’s reform efforts.
In response to those comments, senior Moody’s official Marie Diron said on Friday that the ratings agency has been encouraged by the “vast reform agenda” undertaken by the Chinese authorities to contain risks from a rapid buildup in debt.
Moody’s believes that the reforms may slow the pace at which debt is building up, but China’s debt will not drop dramatically and it will not be enough to arrest rising debt, Diron said.
Diron, associate managing director of Moody’s Sovereign Risk Group, made the comments in a webcast.
China may no longer get an A1 rating if there are signs that debt is growing at a pace that exceeds Moody’s expectations, Li Xiujun, vice president of credit strategy and standards at the ratings agency, said in the same webcast.
“If in the future China’s structural reforms can prevent its leverage from rising more effectively without increasing risks in the banking and shadow banking sector, then it will have a positive impact on China’s rating,” Li said.
But Li added: “If there are signs that China’s debt will keep rising and the rate of growth is beyond our expectations, leading to serious capital misallocation, then it will continue to weigh on economic growth in the medium term and impact the sovereign rating negatively.”
“China may no longer suit the requirement of A1 rating.”
Li did not give a specific target for debt levels nor timeframe for further assessments.
For more about China, watch Fortune’s video:
Government-led stimulus has been a major driver of China’s economic growth over recent years, but has also been accompanied by runaway credit growth that has created a mountain of debt – now standing at nearly 300 percent of gross domestic product (GDP).
“The financial and policy capacity that the Chinese government has to implement such measures and to mitigate some of the default risks is a very important element in supporting the rating at A1, which is the fifth highest rating in our tier, and our view that the outlook of that rating level is stable,” Diron said.
China has vowed to lower its debt level by rolling out measures such as debt-to-equity swaps, state-owned enterprises (SOEs) mixed-ownership reforms, reduction of excess capacity, and more recently regulatory tightening in the shadow banking sector.
But authorities are also keen to meet official economic growth targets, and moves so far have been cautious, especially heading into a key political leadership reshuffle later this year.
While Moody’s expects China’s growth to slow to around 5 percent in coming years, from 6.7 percent last year, the economy will remain robust, and the likelihood of a hard landing is slim, Diron said.