China gives green light for credit default swaps

China’s central bank has given the green light for credit default swaps to start trading in the country’s interbank markets for the first time, adding another financial tool to diversify credit risks and nurture the healthy growth of the capital markets.

The move covers swaps tied to the debt of companies, countries or multinational agencies, according to a statement by the National Association of Financial Market Institutional Investors (NAFMII), a central bank unit that acts as a guild for the issuance of bonds and swaps.

The first batch of the products could be expected to be underwritten by insurers, bank-affiliated asset managers and companies that process bad debt for banks, traders said.

“It’s a very important step to discover how to price credit risks in China, and for investors to be able to hedge” against risks, said Kun Shan, head of local markets strategy at BNP Paribas in Shanghai. “More importantly, banks in China will now have a new tool to manage credit lines and risks.”

As many as 18 Chinese bonds missed their payments this year, compared with seven for all of last year, according to Bloomberg’s data. The amount of non-performing loans among Chinese banks climbed in the first-half to an 11-year high of 1.4 trillion yuan (US$210 billion). The ratio of bad loans rose to 1.75 per cent as of the same period.

“As we have started to see bond defaults in the Chinese markets, the creation of a CDS market will mean that investors can have more market visibility on credit risk and mitigate potential exposures to defaults,” said Mushtaq Kapasi, Chief Representative, Asia-Pacific at the International Capital Market Association.

The previous practice of government aid on debt distorts the cost of capital, allowing many companies to wallow in debt. Now, the People’s Bank of China wants to use default swaps as an additional tool to help the government roll back its legacy role as guarantor.

“The CDS is an extremely important and efficient hedging tool,” said Keith Noyes, regional director of the International Swaps and Derivative Association. “China’s debt markets have been growing and, at the same time, the Chinese government has signalled a willingness to allow Chinese corporations to default. Under this scenario, the need for effective risk management will only become more crucial to market stability.”

The government’s withdrawal of its guarantees makes the creation of the derivatives all the more necessary, and could even be seen as a signal by regulators of a higher tolerance for defaults, said Tony Tang, head of corporate ratings at Dagong Global Credit Rating in Hong Kong.

“Regulators will monitor the usages and issuance of all these instruments. Once they think the level of issuance and sophistication is satisfactory, the government may loosen the support for zombie companies and let even more defaults occur,” he said.

This article has been corrected to say in third paragraph that the CDS can be underwritten by asset-management companies for banks.