Moody's Investors Service on Wednesday downgraded China's credit rating from stable to negative, pointing to worries about the government's potential debt load, the vast sums of money flowing out of the country and ability of Chinese officials to push through reforms.

The demotion raised a red flag about the challenges facing the world's second-largest economy. The country recently recorded its slowest pace of growth in 25 years with the gross domestic product growth squeaking to 6.9% in 2015.

The rating service did reaffirmed China’s Aa3 rating, the fourth highest on its scale, on the country’s long-term debt, citing the country's fiscal and foreign-exchange reserve buffers which continue to be reasonable. It did, however, say that it could downgrade the rating if it observed a slowdown in the pace of reforms needed to support sustainable growth and to protect the government's balance sheet.

Chinese government debt has been rising relative to the size of the economy and policymakers are encouraging banks to give more loans to try to offset slowing growth. The concern is that by doing so, the central government in Beijing could end up responsible not just for its own debts, but for those of regional and local authorities, major banks and huge state-owned enterprises.

Government debt rose to 40.6% of China's GDP at the end of 2015 from 32.5% in 2012 according to its estimates. Moody’s expects debt to further increase to 43.0% by 2017 and it expressed uncertainty about the Chinese authorities' capacity to implement reforms to address imbalances in the economy.

[MOODY’S] DEMOTION RAISED A RED FLAG ABOUT THE CHALLENGES FACING THE WORLD'S SECOND-LARGEST ECONOMY.

Moody’s Ratings-Why?

What is Moody’s and why is it important? Moody’s was founded by John Moody in 1909 with the goal of assessing the credit worthiness of countries and companies and judging their ability in dealing with their debt instruments.

The rating system ranges from AAA for the safest investments to C for investments with “little prospect” of getting back money or interest. The grades matter especially in today’s global market because they measure the growth and stability of international and domestic markets which now encompass more than $80 trillion of rated bonds and other fixed-income securities.

Moody’s is one of three rating services and its scores are the most sought after. When rating a country, the team at Moody’s reviews factors such as money coming in from taxes, the amount of debt the country owes, prospects for growth and how likely the government is to close the gap between money coming in and money going out.

Credit rating is by nature subjective as it involves projecting the future. Furthermore, because long-term credit judgments involve so many factors unique to particular industries, issuers, and countries, an attempt to reduce credit rating to a formulaic methodology could be misleading and result in mistakes. Moody's employs a multidisciplinary or "universal" approach to risk analysis, which relies on the judgment of a diverse group of credit risk professionals who weigh the relevant factors in light of a variety of plausible scenarios for the issuer and then reach a conclusion on what the rating should be.

China’s Downgrade

By downgrading China, Moody’s draws public attention to the challenges facing the world’s second largest economy. Its change in status points to the uncertainty about policy priorities and sends a warning that there is the risk of a downward spiral in which pressure on the yuan and dwindling confidence in the Chinese government's ability to manage the situation could drive even more money out of the economy.

Some analysts have expressed concern that despite its claims to the contrary, China could eventually be forced to allow another steep devaluation of the yuan that could set off turmoil in global markets. Moody’s doubts that Chinese officials will put important reforms such as overhauling the country's sprawling state-owned enterprises ahead of achieving the government's annual growth target and warn that an "Incomplete implementation or partial reversals of some reforms risk can undermine the credibility of policymakers."