BERLIN (Reuters) - Global ratings agency Moody's on Monday downgraded Volkswagen by one notch to Baa1 from A3, citing sector headwinds, structural challenges, ongoing need for investment and fierce competition in China.

"The downgrade to Baa1 reflects the recent contraction in operating margin and free cash flow generation, with limited expectation of a material recovery over the next quarters," Moody's said in a statement.

The rating still places the company three notches above junk territory.

Last week, Volkswagen forecast another challenging year of ramping up electric vehicle sales, cutting costs and navigating trade tensions amid fierce competition with cheaper and faster rivals in China.

The carmaker is in the midst of deep changes including new models and cost cuts in its two main markets of China and Germany, with earnings forecast to drop in China by up to 1 billion euros ($1.09 billion) in 2025.

"These measures, provided a successful execution could support an improvement in profitability by 2026/27," Moody's said in its statement.

It added that Volkswagen's robust balance sheet "with low leverage and very good liquidity ... gives the company time to implement strategic shifts and manage industry challenges."

($1 = 0.9167 euros)

(Writing by Friederike Heine; Editing by Ludwig Burger)