SHANGHAI/BEIJING (Reuters) - Moody’s Investors Service downgraded China’s credit ratings on Wednesday 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-fueled 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 ratings 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”.

“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 are moving 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,” it 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.

World stocks inched lower after the move, though Shanghai's main index .SSEC recouped early losses to end marginally higher. [MKTS/GLOB]

“After being very much at the front and center of global risk sentiment at the beginning of last year, the Chinese slowdown story has been almost forgotten, with politics throughout Europe and the U.S. taking the limelight,” said David Cheetham, chief market analyst at brokerage XTB.

The yuan currency CNH=D3 briefly dipped against the U.S. dollar in offshore trading, as did the Australian dollar AUD=, often seen as a proxy for China risk.

“It’s going to be quite negative in terms of sentiment, particularly at a time when China is looking to de-risk the banking system (and) when there’s going to be some potential restructuring of SOEs,” said Vishnu Varathan, Asia head of economics and strategy at Mizuho Bank’s Treasury division.

GROWTH TO SLOW

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.

“We understand the risk and the reason for downgrade, but due to China being a unique system – (with a) closed capital account and strong government control over all important sectors - it can tolerate a higher debt level,” said Edmund Goh, a Kuala Lumpur-based investment manager at Aberdeen Asset Management.

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The slowing economy has become an increasingly sensitive topic in China, with authorities directing mainland Chinese economists and journalists toward 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 signaled 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 toward 5 percent in coming years, but the cooldown is likely to be gradual due to further doses of fiscal stimulus, Moody’s said.

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DEBT UNDER CONTROL?

The Finance Ministry said continued mid- to high-level economic growth “will provide fundamental support to fend off local government debt risks. China’s government debt risks will not change dramatically in 2018-2020 from 2016.”

The state planner, the National Development and Reform Commission (NDRC), said debt risks are generally controllable as measures to lower corporate leverage have achieved initial results, and systemic risks from debt are relatively low.

Government-led stimulus has been a major driver of China’s 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).

Julian Evans-Pritchard, China economist at Capital Economics in Singapore, said steps to resolve the debt overhang, such as debt-for-equity swaps at state companies, were insufficient to deal with problem.

“It’s reached the point where the bad debt problem is just so large the government will have to step in to resolve it at some point, and that obviously means at some point a sizeable increase in government debt,” he said.

Moody’s said it expects the government’s direct debt burden to rise gradually toward 40 percent of GDP by 2018 “and closer to 45 percent by the end of the decade”.

A growing number of economists believe that a massive bank bailout may be inevitable in China as bad loans mount. Last September, the Bank for International Settlements (BIS) warned that excessive credit growth in China signaled an increasing risk of a banking crisis within three years.

Moody's lowered Agricultural Bank of China's 601288.SS long-term deposit and senior unsecured debt ratings to A2 from A1, on par with Bank of Communications' 601328.SS, which the agency put on review for possible downgrade.

Ratings for state-owned Bank of China 601988.SS, China Construction Bank 601939.SS and Industrial and Commercial Bank of China 601398.SS were affirmed at A1, with Moody's citing their very high level of government support.

For a graphic on China's debt problem, click here