Moody's Investors Service cut its rating on China's debt for thefirst time since 1989, challenging the view that the nation'sleadership will be able to rein in leverage while maintaining thepace of economic growth.

Stocks and the yuan slipped in early trading after Moody'sreduced the rating to A1 from Aa3 on Wednesday, with markets paringlosses in the afternoon. Moody's cited the likelihood of a“material rise” in economy-wide debt and the burden that will placeon the state's finances, while also changing the outlook to stablefrom negative.

It's “absolutely groundless” for Moody's to argue that localgovernment financing vehicles and state-owned enterprise debt willswell the government's contingent liabilities, according to aresponse released by the Ministry of Finance. The ratings companyhas underestimated the capability of the government to deepenreform and boost demand, the ministry said.

It wouldn't be the first time a rating company was behind thecurve, nor is such pushback unique — U.S. Treasury officialsquestioned the credibility of a 2011 downgrade from Standard &Poor's. Still, the move underscores broader doubts over whetherPresident Xi Jinping's government can simultaneously cut excessiveleverage and steady growth, all with a twice a decade reshuffle oftop party posts looming later this year.

“It is a psychological blow that China will not take kindly toand absolutely speaks to the rising financial pressures,” saidChristopher Balding, an associate professor at the HSBC School ofBusiness at Peking University in Shenzhen. That said, “it doesn'tmatter much in the grand scheme of things because so much ofChinese debt is held by state or quasi-state actors and minimalamounts are international investors,” he said.

The Aussie dollar slumped and iron ore led a decline inindustrial commodities. Stocks were mixed, while oil rose.

Total outstanding credit climbed to about 260% of GDP by the endof 2016, up from 160% in 2008, according to Bloomberg Intelligence.At the same time, China's external debt is low by internationalstandards, at around 12% of gross domestic product, according tothe International Monetary Fund, meaning that a downgrade isn'tlikely to be as disruptive as it would be for nations more relianton international funding.

Overseas institutions' holdings of onshore bonds dropped to 830billion yuan ($121 billion) as of the end of March, from 853billion yuan three months earlier, People's Bank of China datashow. That's less than 1.5% of 63.7 trillion yuan of outstandingnotes, according to Bloomberg calculations based on the centralbank data.

Moody's last cut China's sovereign rating in 1989, when itdowngraded the sovereign to Baa2 from Baa1, according tospokesperson, Manvela Yeung.

Rating Warnings

Moody's lowered China's credit-rating outlook to negative fromstable in March 2016, citing rising debt, falling currency reservesand uncertainty over authorities' ability to carry out reforms.About a month later, S&P Global Ratings also warned that risinglocal debt was pressuring the nation's rating.

S&P currently rates China's foreign and local-currencylong-term debt at AA- with a negative outlook, and Fitch places anA+ rating on both foreign and local currency long-term debt with astable outlook. Moody's move puts China parallel in their rankingswith countries including Japan, Saudi Arabia and Estonia.

Those ratings contrast with home-grown Dagong Global CreditRating Co.'s AA+ on China's sovereign debt in local currency termsand AAA in foreign currency terms, the highest level. By contrast,Dagong rates the U.S. as A- in both currency terms, below Russiaand France.

Still, Moody's isn't hitting the panic button.

“The stable outlook reflects our assessment that, at the A1rating level, risks are balanced,” Moody's said in the statementWednesday. “The erosion in China's credit profile will be gradualand, we expect, eventually contained as reforms deepen. Thestrengths of its credit profile will allow the sovereign to remainresilient to negative shocks, with GDP growth likely to stay strongcompared to other sovereigns, still considerable scope for policyto adapt to support the economy, and a largely closed capitalaccount.”

Read Gadfly's take on the curious case of Moody's and its Chinasovereign cut

While China's debt risks have been swelling for years, the cutby Moody's comes as some of those pressures ease. Nominal economicgrowth in the first quarter rose at the fastest pace since 2012 —11.8% in current-price terms — making the problem of excessleverage a little more manageable, while the return of factoryprice inflation is beefing up profits for indebted state-ownedindustries, helping them service and repay loans.

With the economic structure improving and government debt undercontrol, the economy will continue to expand at a medium-to-fastpace, helping prevent debt risks, the finance ministry said in itsstatement Wednesday.

“This cut is not solidly grounded,” said Wen Bin, chief analystat Minsheng Securities in Beijing. “Policy makers have been wellaware of the debt and leverage issues, and actions have been taken.It is a smart move if no one sees the problem and you are the firstto flag it. But less so if it has already been noticed andaddressed.”

The move may still discomfort China investors in that ithighlights the risks to the economy rather than the ability of thegovernment to control them.

“The downgrade comes at a bad time,” said Tom Orlik, chief Asiaeconomist at Bloomberg Intelligence in Beijing, adding that it willmake it more expensive to open the country's bond market. “China'sleaders from President Xi Jinping down have said that structuralreform and financial stability are priorities. Still, progressremains faltering and in some respects movement is in the wrongdirection.”

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.