Why China’s Debt Downgrade Is a Tempest in a Teacup

 Last week, Moody’s downgraded its credit rating on Chinese debt. So what?

Since then, the talking heads on CNBC have been out in full force claiming that China is doomed to default on its growing debts.

But this tempest in a teacup shouldn’t worry you one bit. In fact, the Moody’s downgrade could be a wonderful contrarian buy signal for Chinese shares. Here’s why…

Granted, China’s debts have ballooned in recent years. In fact, total Chinese household and corporate debt now stands at 220% of GDP. It has expanded by $19 trillion over the past eight years alone.

It’s easy to see how these “scary” headline numbers could be used to frighten investors away, especially when those figures get taken completely out of context from what’s actually happening in China today.

First, financial stability is actually improving in China right now, and it has been steadily on the upswing since the end of last year. The Bloomberg China Financial Stability Index (see chart below) is clearly in an uptrend again, after bottoming in the fourth quarter of last year. The trend has been boosted by gains in Chinese stocks, tighter monetary conditions and a slowdown in capital outflows from China.

In other words, the worst is over already and Moody’s is late to the party … again!

Second, another reason so-called experts get it wrong with China is that they forget how the Red Dragon funds the vast majority of its debt internally. State-run companies within China hold most government and corporate debt.

That’s why a credit downgrade isn’t about to trigger a wave of bond selling, because Beijing simply won’t allow it to happen.

China’s total external debt – that is, held by investors outside of China – is just a tiny 13% of GDP, a very low level compared to many other nations. For example, Japan’s external debt equals 74% of its GDP while in the U.S. it’s 97%! Meanwhile, foreigners own just 3% of China’s debt.

Third, still if you want to pick on China for its growing liabilities, then at least be fair enough to look at the asset side of its financial statement. The fact is, China saves almost 45% of GDP, far and away the highest savings rate of any large economy on earth.

This means China doesn’t need to borrow from foreigners, it can fund its economic growth internally. It’s self-sufficient, so a credit rating downgrade won’t phase China’s financial markets in the slightest.

And sure enough, the iShares China Large-Cap ETF (FXI), which is the largest ETF tracking Chinese stocks, is up 18% year-to-date, far ahead of the 6.5% gain for the Dow so far this year.

Bottom line: Chinese stocks have enjoyed nice gains so far this year, and members of my Real Wealth Report have profited nicely thanks to FXI and several other timely recommendations.

That said, I wouldn’t be a bit surprised to see a pullback at some point soon, probably triggered by a correction in U.S. stocks. But I would view any pullback as a great buying opportunity in China, regardless of Moody’s downgrade.

Remember, the U.S. suffered a credit-rating downgrade in 2011, which the talking heads on CNBC said was the beginning of the end for our stock market. The reality is, the Dow has more than doubled in value since then.

Good investing,

Mike Burnick