* Moody's cuts rating to A1 from Aa3, outlook stable
* Moody's says reforms won't prevent rise in economy-wide debt
* Expects China growth to slow to close to 5 pct in coming years
* S&P rates China one notch higher, on negative watch
* Shanghai stocks down 1 pct, offshore yuan briefly dips (Adds economist, analyst comments, detail on bonds)
SHANGHAI/BEIJING, May 24 (Reuters) - Moody's Investors Service downgraded China's credit ratings on Wednesday, saying it expects the financial strength of the world's second-biggest economy will erode in coming years as growth slows and debt continues to rise.
The one-notch downgrade in long-term local and foreign currency issuer ratings, to A1 from Aa3, comes as the Chinese government grapples with the challenges of rising financial risks stemming from years of credit-fuelled stimulus.
"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," the rating agency 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 tightening regulatory supervision.
While the downgrade is likely to modestly increase the cost of borrowing for the Chinese government and its state-owned enterprises (SOEs), it remains comfortably within the investment grade rating range.
China's Shanghai Composite index fell more than 1 percent in early trade before paring losses, while the yuan currency in the offshore market briefly dipped nearly 0.1 percent against the U.S. dollar after the news.
The Australian dollar, often see as a liquid proxy for China risk, also slipped.
One trader at a foreign bank in Shanghai said the spread between benchmark government bonds and those issued by SOEs in U.S dollars widened by 2-3 basis points.
"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 has Japan at the same A1 rating China is now on.
"We understand the risk and the reason for downgrade but due to China being a unique system on its own closed capital account and strong government control over all important sectors - it can tolerate a higher debt level," said Edmund Goh, a Kuala Lumpur-based investment manager at Aberdeen Asset Management.
Moody's has no specific timetable for re-visiting China's rating, but would monitor conditions on a regular basis, said Marie Diron, associate managing director of Moody's Sovereign Risk Group.
More than two hours after the announcement from Moody's, no Chinese state media had published news stories about the downgrade.
The slowing economy has become an increasingly sensitive topic in China, with authorities directing mainland Chinese economists and journalists towards more positive messaging.
When Moody's cut its outlook on China in March 2016, former Finance Minister Lou Jiwei said at that time the government didn't "care much" about it.
Lou said China understood rating agencies' concerns about problems such as local government debt, but the government had taken measures to address the issue and it didn't need to consult or seek support from the agencies.
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.
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, Moody's said.
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 gross domestic product (GDP).
Julian Evans-Pritchard, China Economist at Capital Economics in Singapore, said steps to resolve the debt overhang, such as debt-for-equity swaps at state-owned enterprises, were insufficient to deal with problem.
"As a result, its reached the point where the bad debt problem is just so large the government will have to step in to resolve it at some point and that obviously means at some point a sizeable increase in government debt," he said.
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". (Additional reporting by Ryan Woo and Yawen Chen in Beijing, Nichola Saminather in Singapore, Andrew Galbraith in Shanghai and Umesh Desai in Hong Kong; Editing by Lincoln Feast, Shri Navaratnam and Kim Coghill)