Flee from Chinese CDOs!

China is about to go down exactly the same path that led to America's and thus the globe's financial meltdown of 2008. In a nutshell, the China Banking Regulatory Commission wants China's banks to issue collateralized debt obligations (CDOs) to domestic as well as international markets. Some RMB50 billion has been granted by the regulators already.

CDOs basically repackage together cash-flow generating assets sliced and diced into tranches that can be sold to investors, with the quality descending the further down as the tranches go out. Senior tranches are safer because they have the first priority on the collateral behind them, which are made up of mortgages, bonds and loans that serve as collateral. The senor tranches generally have higher credit ratings and offer coupon rates.

Unfortunately, contrary to America's slippery path, these CDOs won’t be rated by the rating agencies at all, the rating agencies apparently having learned their lesson with the massive CDO scandal starting in 2008. With a debt pile equivalent to nearly 250 percent of GDP, these CDOs would "...whittle back debts at Chinese banks and move some of the risk outside the domestic financial system, according to a March 3 article in the Financial Times. “According to official figures, such debts have reached RMB 1.27 trillion (US$194 billion), while analysts estimate the real number to be many times higher."

It is good that rating agencies won't feed the world the same amount of conflicted lies as in America's case. However, the danger is considerable. Nobody knows what is in this pile of RMB1.27 trillion in debt. Remember the middle of the last decade when China was forced to recapitalize its banks, which were believed to carry US$800 billion in nonperforming loans, which Standard & Poor’s estimated at the time to be 40 percent of loans. China is still flogging some of those assets from asset management companies.

The enormous expansion of the economy following the 2009 global meltdown poured unknown trillions – trillions this time – into assets that are probably as dodgy as they were last time around.

I would not be surprised if particularly sovereign wealth funds pile in, thus putting their pensioners at risk. Another danger is more heinous: by successfully issuing such debt, this represents an easy way out for China's banks. They will be able to keep writing dicey loans and then passing the hot potato on to gullible investors, as the world’s bankers did in the run-up to the 2009 financial meltdown.

It isn’t just China’s problem. One key reason for market bewilderment is simple; the global economy is plagued by an increasing excess demand for money and by an excess supply of goods. Such time means that there is no spare cash for asset markets, and that the profit outlook is miserable thanks to low turnover and slim margins.

Thus, quite why at the G20 governments are calling for further fiscal expansion is confusing: we have too much stuff around already! Ditto China, which has exactly the same Economic Time® (which is one explanation for her miserable markets.)

Markets are busily expecting massive reflation to result from the high-level meetings held in Beijing as of Saturday, 5th March and to run through the 15th. Here is what the Financial Times warns of in its editorial of 4th March 2016, p.8: "Fiscal expansion is probable, but the form this takes is crucial if it is to aid a rebalancing towards services and consumption. The temptation may be to spend on the traditional industrial and infrastructure projects; but the need is to focus on tax breaks and spending on the services sector and on social security."

Potentially misguided. Thus, if China's fiscal reflation is directed towards even more capacity in traditional industries, e.g. for more state-owned factories, roads and bridges, then China's excess supply of goods will be exacerbated even more. So how can profits improve against the backdrop of even more pronounced excess capacities, an "excess supply of goods"? My guess is that the expansion of existing capacity is what will be done by way of a cheap fix to China's 20percent unemployment rate...

Investment Implications

Do NOT buy the chimera of Chinese CDOs: nobody trusts Chinese numbers! Keynes: if China conducts traditional Keynesian fiscal expansion, aka the expansion of existing capacities, then forget any medium-term improvement to China's profits outlook. The jury is still out; thus, we will be following this story of fiscal expansion very closely over the next two weeks.

In any instance: fiscal as well as monetary expansion means that the supply of RMB rises, so its exchange rate falls against the dollar. That will irk American Congress and thus lead to increased tensions in the South China Sea....meaning that you buy defense shares on both sides of the Pacific.

Enzio von Pfeil is the Investment Strategist for Private Capital Limited, a commission-free Hong Kong financial advisory firm