Is China’s Debt Bubble About to Pop?

With yields on most U.S. stocks at paltry levels, investors have increasingly turned to foreign markets to keep their income flowing. China has been a big magnet for this investment money, but the country’s mountain of debt is a worsening danger.

Moody’s Investor Services cut China’s sovereign credit rating on Tuesday, knocking it down a notch from Aa3 to A1. The rating firm’s reasoning behind the move essentially boils down to this: China is a developed nation still acting like an emerging one.

The problem began back in 2008 when, in response to the financial crisis, China went on a debt-financed spending spree. It built housing developments, highways, railroads, airports, you name it, largely paid for with money borrowed by local-governments and state-run companies. That’s not unusual in and of itself — it’s the Keynesian prescription to treat a recession. The problem is that, nearly a decade later, China still hasn’t stopped as it tries to maintain its targeted economic growth of between 6.5% and 7%.

As a result, the country’s total debt is now high even for a developing country and on par with the developed Western world, reaching about 15% of China’s annual output. If China continues with this debt-financed building spree, its debt load will only get worse. As the economy gets bigger, it will take even more borrowing to achieve the desired growth target.

The downgrade rattled Chinese stocks, which dropped to an almost 7-month low before recovering for a slight gain on the day. Despite that turnaround, it’s a safe bet that investors will be closely watching the country over the coming months.

It’s true that China is uniquely positioned to sustain all this borrowing. Despite the growth of regional and local banks in the country, the government can still maintain a tight grip on the system through its control of the four largest banks. Thanks to its legacy as the workshop of the world, it also has relatively little external debt and $3 trillion in foreign reserves. And while corporate debt has been skyrocketing, Chinese households seem to have kept a handle on their borrowing. So, all things considered, the government could, at least theoretically, deftly deal with a financial crisis.

The real issue is that if China doesn’t change its policy in terms of targeting specific levels of economic growth, the problem will only grow. Yet the government hasn’t given any indication that it will scale down its target, much less change course entirely. Until that happens, investors will become increasingly wary.

My point here isn’t to dissuade you from looking for higher dividends abroad. In fact, I’m personally fond of China Mobile (NYSE: CHL) and its better than 3% yield. As the largest telecom operator in China and the world, it has a rock-solid balance sheet and generates more than enough free cash flow to cover its dividend. As a result, its shares barely wavered on the downgrade news.

CHL also is an excellent case in point that when you’re investing globally, you need to stay focused on companies with excellent business and strong fundamentals. Otherwise, you could find yourself caught up in unexpected volatility.