Moody's Investors Service Wednesday lowered the outlook on China's credit rating from stable to negative, citing a weakening of fiscal metrics and a continuing fall in foreign exchange reserves.
The rating agency also noted uncertainty over the capacity of authorities to implement the reforms needed to address imbalances in the world's second-largest economy.
Moody's current Aa3 rating on China is seven notches above junk so even if the agency were to follow up on its warning and lower the rating, investors won't have to suddenly start selling the country's bonds.
Still, the warning underscores how the build-up in credit in the country's stuttering economy is making market observers nervous.
Rival Standard & Poor's assesses China's creditworthiness at similar levels to Moody's, while Fitch rates China a notch lower. S&P and Fitch both have stable outlooks on the country.
Chinese markets did not immediately react to the outlook revision. The Shanghai composite was near flat at 2,735.21,while the dollar/yuan rate was at 6.5518 against Tuesday's close of 6.5500. The bid yield on China's benchmark 10-year local currency bond was steady at 2.91 percent.
Moody's noted that government debt had risen from 32.5 percent of gross domestic product (GDP) in 2012 to 40.6 percent at the end of 2015.
Moody's forecasts the metric to rise further to 43 percent of GDP by 2017 as Beijing spends more to revive growth that has slowed to the lowest in over two decades.
"While not our base case scenario, the government's fiscal strength would be exposed to additional weakening if underlying growth, excluding policy-supported economic activity, remained weak," Moody's said in a statement accompanying its outlook change on Wednesday.
"In such an environment, the liabilities of policy banks would likely increase to fund government-sponsored investment, while the leverage of state-owned enterprises (SOEs) — already under stress — would rise further."
Another source of unease is the flood of capital out of China in recent months.
Slowing economic growth, a stock market plunge last summer (albeit from vertigo-inducing levels), and volatility in currency markets have caused investors take fright.
China's foreign reserves fell $99.5 billion in January to $3.23 trillion, the lowest level since May 2012, as the central bank intervened aggressively to prop up its currency. Goldman Sachs reckoned capital outflows in China amounted to $88 billion during that month.
Moody's acknowledged that China's foreign exchange reserves, the world's largest, remained substantial, especially in relation to China's external debt.
But the ratings agency warned that sharp decline in reserves in recent months could still portend further capital outflows if pressure on the yuan persisted and confidence in the ability if policymakers to shore up confidence wavered.
The policy options open to China come with their own risks.
Tightening capital controls would fuel concerns over China's commitment to financial sector reforms — as it has repeatedly promised it is, as recently as last weekend's G-20 meeting — while intervening vigorously in the currency markets would siphon cash from the the financial system at a time the economic outlook looks shaky. (A cut in banks' reserve requirement ratio on Monday was aimed at boosting liquidity in the banking system, just days after fears about liquidity drying up caused a sudden rout in local stock markets.)
Letting the currency weaken to preserve reserves, on the other hand, would accelerate capital outflows.
According to Moody's, multiple policy objectives of maintaining economic growth, implementing reforms and curbing market volatility were testing China's institutions.
The rating agency expressed concern that fiscal and monetary policy measures to ensure the government's economic growth target of 6.5 percent was met could slow reforms, including those related to SOEs.
"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.
So what would trigger a change in the rating or the outlook?
Moody's said an upgrade in the outlook to stable was possible if the government succeeded in shoring up finances and restructured SOEs. A moderation in capital outflows would also help.
A downgrade was possible if the reform drive slows, public debt rose and capital outflows accelerated, Moody's said.