* Moody's cuts rating to A1 from Aa3, outlook stable
* Moody's says reforms won't prevent rise in economy-wide debt
* S&P rates China one notch higher, on negative watch
* Shanghai stocks down 1 pct, offshore yuan briefly dips (Adds detail on Chinese govt measures, economic performance)
SHANGHAI, May 24 (Reuters) - Moody's Investors Services downgraded China's long-term local and foreign currency issuer ratings on Wednesday, citing expectations that the financial strength of the world's second-biggest economy would erode in the coming years.
The downgrade by one notch to an A1 rating from Aa3 comes as the Chinese government grapples with the challenges of slowing economic growth and rising financial risks stemming from soaring debt.
"The downgrade reflects Moody's expectation that China's financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows," Moody's said in a statement.
"While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government," it said.
The ratings agency also changed its outlook for China to stable from negative.
China's top leadership has identified the containment of financial risks and asset bubbles as a top priority this year. All the same, authorities have moved cautiously to avoid knocking economic growth, gingerly raising short-term interest rates.
While the downgrade is likely to modestly increase the cost of borrowing for the Chinese government and its state-owned enterprises, it remains comfortably within the investment grade rating range.
China's Shanghai Composite index fell more than 1 percent in early trade, while the yuan currency in the offshore market briefly dipped nearly 0.1 percent against the U.S. dollar after the ratings agency announced its decision. The Australian dollar, often see as a liquid proxy for China risk, also slipped.
"It's quite clear that its going to be quite negative in terms of sentiment, particularly at a time when China is looking to derisk the banking system, as well as at a time when theres going to be some potential restructuring of SOEs," said Vishnu Varathan, Asia head of economics and strategy at Mizuho Bank's Treasury division.
GROWTH TO SLOW
In March 2016, Moody's cut its outlook on China's government credit ratings to negative from stable, citing rising debt and uncertainty about the authorities' ability to carry out reforms and address economic imbalances. Rival ratings agency Standard & Poor's downgraded its outlook to negative in the same month. S&P's AA- rating is one notch above both Moody's and Fitch Ratings' A+ rating.
Moody's said its now stable outlook reflected the assessment that risks were balanced.
China's potential gross domestic product growth was likely to slow towards 5 percent in the coming years, but the slowdown is likely to be gradual due to expected fiscal stimulus, it said.
Authorities have stepped up efforts over the last several months to curb debt and housing risks, and a raft of recent data has signaled a cooling in the economy, which grew a solid 6.9 percent in the first quarter.
Government-led stimulus has been a major driver of economic growth over recent years, but the pump-priming has also been accompanied by runaway credit growth and has created a mountain of debt - now standing at nearly 300 percent of GDP.
Moody's said it expects the government's direct debt burden to rise gradually towards 40 percent of GDP by 2018 "and closer to 45 percent by the end of the decade".
Economy-wide debt of the government, households and non-financial corporates would also continue to rise, it said.
"Taken together, we expect direct government, indirect and economy-wide debt to continue to rise, signaling an erosion of China's credit profile which is best reflected now in an A1 rating," it said. (Additional reporting by Ryan Woo in Beijing and Nichola Saminatha in Singapore; Editing by Lincoln Feast and Shri Navaratnam)