Moody’s Investors Service has cut its rating on China’s debt to A1 from Aa3 and changed the outlook to stable from negative. It cited the likelihood of a “material rise” in economy-wide debt and the burden that will place on the state’s finances. The offshore yuan dipped after the downgrade. President Xi Jinping and other top leaders are seeking to rein in credit risks in the financial system, while ensuring there is enough lending to keep the economy growing by at least 6.5% this year. Total outstanding credit climbed to about 260% of GDP by the end of 2016, up from 160% in 2008, according to Bloomberg Intelligence. “It is a psychological blow that China will not take kindly to and absolutely speaks to the rising financial pressures in China,” said Christopher Balding, Associate Professor at the HSBC School of Business at Peking University in Shenzhen. That said, “It doesn’t matter much in the grand scheme of things because so much of Chinese debt is held by state or quasi-state actors and minimal amounts are international investors.” Overseas institutions’ holdings of onshore bonds dropped to CNY830 billion as of the end of March, from CNY853 billion three months earlier, People’s Bank of China data show. That is less than 1.5% of CNY63.7 trillion of outstanding notes. “The stable outlook reflects our assessment that, at the A1 rating level, risks are balanced,” Moody’s said in the statement. “The erosion in China’s credit profile will be gradual and, we expect, eventually contained as reforms deepen,” Moody’s added.

Moody’s cut Hong Kong’s credit rating from Aa1 to Aa2, following its first downgrade to China’s rating since 1989, citing the city’s “close and tightening” linkages with the mainland. Total mainland-related lending in the city rose to HKD3.6 trillion at the end of 2016, up 3.5% compared with last June, while other non-bank exposures increased by 11.4% to HKD1.2 trillion. Moody’s also cut the ratings of 26 Chinese state-owned enterprises (SOEs). A downgrade could increase the debt financing cost for the companies. Among the affected companies were China Mobile, China National Offshore Oil Corp (CNOOC) and China Petrochemical Corp (Sinopec). Moody’s downgraded Agricultural Bank of China one notch, while the ratings agency left its ratings on China’s three other large state-owned banks unchanged. Dagong Global Credit Rating Co maintained its local and foreign currency sovereign credit ratings for China at AA+ and AAA respectively, both with stable outlooks.

China’s Ministry of Finance responded to Moody’s sovereign downgrade with a statement on its website saying the agency used “inappropriate” methods to overestimate the country’s economic difficulties and underestimated Beijing’s ability to handle such challenges.“Moody’s views that the debt scale of the real economy will grow rapidly, that reforms are having difficulties showing effects, and that the government will continue to stimulate growth, overestimated the difficulties China is confronting and underestimated the government capability in deepening structural reform and appropriately expanding aggregated demand,” the Ministry said.