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SHANGHAI, May 24 (Reuters) - China stocks fell more than 1 percent before recouping some of the losses incurred on Wednesday morning in the wake of Moody's downgrading of China's debt ratings - aggravating a market already worried by tighter regulation, rising borrowing costs and signs of an economic slowdown.
Moody's Investors Services downgraded China's long-term local and foreign currency issuer ratings before China's markets started trading on Wednesday, citing expectations that the country's financial strength would erode in coming years.
The downgrade has had "a negative psychological impact on the market," said Tian Weidong, strategist at Kaiyuan Securities, adding Beijing's campaign to clean up the financial system was already driving up market rates and causing retail investors to panic.
China's benchmark stock indexes fell more than 1 percent shortly after the market opened, before recovering some losses.
By the lunch break, the CSI300 index fell 0.3 percent to 3,412.76 points while the Shanghai Composite Index lost 0.4 percent to 3,050.94 points.
The market has already been hobbled in recent weeks with signs that Beijing's regulatory campaign targeting shadow banking and risky investment in the financial system is pushing up short-term borrowing costs and threatening to slow the economy.
In a rare sign of tightening liquidity in the interbank market, the one-year Shanghai Interbank Offered Rate (SHIBOR) is at 4.3137 percent, exceeding the one-year Loan Prime Rate at 4.3 percent.
Morgan Stanley said in a report on Wednesday that China's interbank interest rates can rise by another 40-50 basis points from current levels in the coming months, to keep pace with the Fed's tightening moves.
Mainland Chinese shares fell across the board, but reaction to the Moody's downgrade was more muted in Hong Kong, where the benchmark index was little changed. (Reporting by Samuel Shen and John Ruwitch; Editing by Eric Meijer)