Moody’s Investors Services downgraded China’s long-term debt ratings on Tuesday from Aa3 to A1. The ratings, for local currency and foreign currency remain solidly in the investment-grade territory. However, Moody’s raised the economy’s outlook from negative to stable.

Moody’s argues that the Chinese financial strength will weaken as debt is expected to rise by the end of decade and as growth continues to decline meanwhile as Chinese government implements reforms in order to restructure the economy towards local consumption. Hinting at Chinese government’s reforms, Moody’s’ in a statement said that, “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 estimated that while the government budget deficit in 2016 was “moderate” at around 3 percent of gross domestic product (GDP), it expected the government's debt burden would rise toward 40 percent of GDP by 2018 and 45 percent by the end of the decade.

As a result of down gradation, Chinese stocks headed for their lowest fall since last October, the Yuan retreated and default risk increased after the Investor Agency cut its rating on the nation’s debt for the first time in  almost three decades. 

The downgrade could increase the cost of borrowing for China. The Chinese debt is concentrated mostly in the state-owned enterprises or the “quasi-state” entities, not international investors, so it is unlikely that the crisis in Chinese debt will result in any spillover to the other economies.

Highlighting the debt situation, Moody’s report stated that “economy-wide debt of the government, households and non-financial corporates will continue to rise, from 256% of GDP at the end of last year”.

The Chinese Authorities have taken steps to contain the rise of State Owned Entities’ debt situation, and have constantly discouraged from any external or internal expansion. The reforms, however, are not expected to bring the change quickly, as China continues to post declining growth rates every year since 2010, including expectations that it would fall to 5% by the end of the decade.

GDP growth has decelerated in recent years from a peak of 10.6% in 2010 to 6.7% in 2016.