Moody's downgraded its outlook on Chinese government debt to "negative" from "stable" on Wednesday, citing uncertainty over authorities' capacity to implement economic reforms, rising government debt and falling reserves.
"Without credible and efficient reforms, China's GDP growth would slow more markedly as a high debt burden dampens business investment and demographics turn increasingly unfavourable. Government debt would increase more sharply than we currently expect," Moody's said in a note on Wednesday.
Moody's said its rating committee had discussed China's status at a meeting on February 9, during which the country's institutional and fiscal strength, as well as its susceptibility to event risks, were reviewed.
The agency said the downgrade was driven by expectations that China's fiscal strength will continue to decline, and the fall in its foreign exchange reserves which have shrunk by $762 billion over the last 18 months.
It also said that policymakers' credibility was at risk of being undermined by incomplete implementation or partial reversals of some reforms.
"Interventions in the equity and foreign exchange markets over the past year suggest that ensuring financial and economic stability is also an objective, but there is considerably uncertainty about policy priorities," Moody's said.
Moody's, however, retained China's Aa3 rating, noting the country's sizeable reserves gave it time to implement reforms and gradually address economic imbalances.
But the agency warned that it could further downgrade China's rating if it saw slowing down of reforms needed to support sustainable growth and to protect the government's balance sheet.
"It's not a worrying sign yet, but rather a negative direction. That's what Moody's is flagging," said Trinh Nguyen, senior economist for emerging Asia at global asset manager Nataxis.
"But they have room to do this. They have one of the lowest government debt as a share of GDP in comparison to other emerging nations. And most importantly, as China has a current account surplus it can fund its own fiscal expansion."
Initial market reaction to the outlook change was muted, although the cost of insuring Chinese government debt against default rose slightly.
"The drivers - local government debt, capital outflows, falling reserves and concerns on the progress of reforms - are all well recognized by investors and a lot of them have arguably already been priced in," agreed Aidan Yao, Senior Emerging Market Asia Economist at AXA Investment Managers.