Moody's Investors Service downgraded China's credit ratings today for the first time in nearly 30 years, saying it expects the financial strength of the economy will erode in coming years as growth slows and debt continues to rise.

The one-notch downgrade in long-term local and foreign currency issuer ratings, to A1 from Aa3, comes as the Chinese government grapples with the challenges of rising financial risks stemming from years of credit-fuelled stimulus.

"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," the rating agency said in a statement, changing its outlook for China to stable from negative.

China's Finance Ministry said the downgrade, Moody's first for the country since 1989, overestimated the risks to the economy and was based on "inappropriate methodology".

A growing number of economists believe that a massive bank bailout may be inevitable in China as bad loans mount.

“Moody’s views that China’s non-financial debt will rise rapidly and the government would continue to maintain growth via stimulus measures are exaggerating difficulties facing the Chinese economy, and underestimating the Chinese government’s ability to deepen supply-side structural reform and appropriately expand aggregate demand,” the ministry said in a statement.

China's leaders have identified the containment of financial risks and asset bubbles as a top priority this year. All the same, authorities have moved cautiously to avoid knocking economic growth, gingerly raising short-term interest rates while tightening regulatory supervision.

At the same time, Beijing's need to deliver on official growth targets is likely to make the economy increasingly reliant on stimulus, Moody's said.

"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," Moody's said.

While the downgrade is likely to modestly increase the cost of borrowing for the Chinese government and its state-owned enterprises (SOEs), it remains comfortably within the investment grade rating range.

In March 2016, Moody's cut its outlook on China's ratings to negative from stable, citing rising debt and uncertainty about authorities' ability to carry out reforms.

Rival ratings agency Standard & Poor's downgraded its outlook to negative in the same month. S&P's AA- rating is one notch above both Moody's and Fitch Ratings, leading to speculation among analysts that S&P could also downgrade soon.

The slowing economy has become an increasingly sensitive topic in China, with authorities directing mainland Chinese economists and journalists towards more positive messaging.

Authorities have stepped up efforts over the last several months to curb debt and housing risks, and a raft of recent data has signalled a cooling in the economy, which grew a solid 6.9 percent in the first quarter.

China's potential economic growth was likely to slow towards 5 percent in coming years, but the cooldown is likely to be gradual due to expected fiscal stimulus, Moody's said.

A growing number of economists believe that a massive bank bailout may be inevitable in China as bad loans mount. (Reuters)

 

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