Moody's said that the outlook for the country's financial strength will worsen, with debt rising and economic growth slowing.
The downgrade is a reflection of the expectations by Moody's that the financial strength of China's economy will erode as debt mounts across the economy due to a potential for growth to slow, said the ratings agency in a prepared statement.
But the Chinese finance ministry hit back at the Moody's decision, claiming it gave a false picture of China's financial outlook.
"To a certain extent, [Moody's] overestimated the difficulties faced by China's economy, and underestimated the Chinese government's ability to deepen the supply-side structural reform and to moderately increase aggregate demand", it said in a statement (link in Chinese). Whilst acknowledging that reforms on the financial system are being implemented, the agency said it is unlikely to prevent a further material rise in economic debt and government liabilities. The Chinese credit profile, for example, is expected to weaken, but the damage is an obstacle that China can overcome in time.
The US ratings agency also changed its outlook for China to stable from negative on the basis of balanced risks.
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In reaction to the Moody's downgrade, analysts at Nomura predicted that high debt levels and other financial risks will contribute to a slowdown in China's growth in the years ahead. In March of a year ago, it cut China's outlook to negative from stable. "China's government debt risks will not change dramatically in the period of 2018-2020 from 2016".
Over the same period, Chinese economic growth fell from 14.2 percent to 6.7 percent in 2016, though that still was among the world's strongest.
In the short-term at least, this is likely to centre on fiscal policy and increased spending by the government and its related entities. China's state planner said debt risks were generally controllable. Despite the stock market's volatility, it has also encouraged equity financing to channel domestic savings into the economy to reduce its reliance on debt for growth.
Guoyuan Securities rose by the daily limit of 10 percent to end at 11.99 yuan, and China Merchants Bank climbed 4.75 percent to close at 22.95 yuan.
In February this year, state-run Xinhua news agency has quoted China Banking Association as saying that the country s bad loans totalled to a whopping Dollars 220 billion last year.