THE eurozone debt crisis and fears of a United States recession have doomsayers unsurprisingly pricing in another global financial meltdown. More of a surprise is that they are taking no chances on China.

The world's second-biggest economy certainly has its problems. It is exposed to any global downturn. Accounting scandals at US-listed Chinese firms have tainted investor perception and a mountain of local government debt has raised worries about the health of Chinese banks.

But investors may have gone too far where China is concerned. Chinese markets have been pushed to absurd levels that are hard to justify unless a major economic and financial crisis occurs in the country, some investors say. And there is little evidence to suggest such a crisis is going to happen.

"If you are bearish on the global economy, double dip and have any other macro concerns, then investors are using a short China position to execute that view," said Jeffrey Yap, head of Asian fixed-income trading at Mizuho Securities in Hong Kong.

"At these levels, I think it is quite overdone as data out of China itself doesn't imply a hard landing or any other concerns."

One reason for the rush into Chinese hedges dates back to the global financial crisis in 2008 and 2009. The financial tsunami sparked by the collapse of Lehman Brothers showed how ill-prepared investors were for so-called "tail risk," essentially rare and potentially catastrophic events.

With fears the world is on the brink again, investment banks have talked up "tail risk" hedges that would have hefty payouts if a crisis happens, so many investors have made sure they are covered.

Fast-money accounts have also been active, building positions to try to profit from the momentum of the market to make up for poor performances elsewhere, several traders, institutional investors and hedge fund managers said.

The result is that looking through the lens of financial markets, China's prospects look worse than they actually are, said a Hong-Kong based hedge fund manager.

"People talk about a hard landing in China. I would like them to define what a hard landing is. Is it around 7 percent growth or minus 1 percent growth? That's a big difference. I think that the markets were pricing stuff that was completely unrealistic," said the manager, who owns offshore Chinese corporate bonds. The manager is not authorised to speak to the media so declined to be identified.

CDS popular

Investors have piled into the CDS (Credit Default Swap) sovereign market to place their China bets, partly because of a lack of other instruments they can use to hedge China-related risks.

"While they may be imperfect, they are just about the only instrument out there now," said Mizuho's Yap.

Net notional volumes in China sovereign CDS have nearly doubled since the start of the year to US$9.2 billion, data on Thomson Reuters CreditViews show.

The spread on five-year CDS blew out to 200 basis points earlier this month from 68 at the start of the year, suggesting growing worries of a debt default.

Such a sharp widening may be justified for some eurozone sovereigns, but the shift in China clearly misprices a country that has close to zero foreign debt and over US$3 trillion in foreign reserves.

"Buying sovereign China CDS has been the de-facto trade to hedge whether it is bond or equity portfolios," said Chi Lo, chief executive of HFT Investment Management, which runs a range of China-focused funds across asset classes including equity, bond and money markets.

In addition, the broad China selloff seemed to ignore the wide array of policy tools at Beijing's disposal to deal with any economic problems, including its ability to print money if needed.

Just last week, an arm of the country's sovereign wealth fund started buying shares in the country's big four banks to boost confidence in the Shanghai Composite Index.

Since many of Chinese mainland's markets are closed to foreign players, investment banks such as Morgan Stanley, JPMorgan and Goldman Sachs have offered clients a panoply of strategies to trade China-related risks - from out-of-the-money puts on South Korean shares and the Taiwan dollar to positions in Australian swaptions which are options on swaps.

Because markets in Australia are so tied to the fortunes of China, they have become a playground for funds.

The effect can be dramatic. When global market volatility struck in August, Aussie swap rates plunged to levels implying repeated rate cuts by Australia's central bank, including a cut in September. Very few economists expect such drastic action, and the central bank has not flagged such policy moves.

One of the ways investors have sought protection against any crisis in China is buying cheap put options on the Australian dollar at strikes such as 50 US cents - less than half the currency's level on Wednesday of US$1.03.

Buying opportunity

Chinese property company stocks and bonds have also been hard hit owing to Beijing's policies to cool housing prices. However, some may now represent a buying opportunity.

Evergrande Real Estate Group Ltd, which Standard & Poor's and Fitch Ratings rank as two notches below investment grade at BB, is one of many big Chinese property companies whose offshore bonds have been hammered.

Its US$1.35 billion in outstanding January 2015 dollar bonds were issued with a 13 percent coupon. The bond price dropped so sharply last month that the yield hit 35 percent. Even now those bonds are yielding 25 percent.

Stocks of mainland property companies and banks are down between 30-50 percent since the start of 2011, helping drive overall forward valuations on the main Shanghai stock index to a record low. Chinese bank stocks listed in Hong Kong are used by many investors to hedge exposure to China in a portfolio because they are relatively liquid and can be shorted.

Hedging tools lacking

So while there are persistent fears about the extent that China's banking sector is vulnerable to informal lending channels, local government debt and the property sector, short selling activity in bank stocks may reflect the lack of adequate hedging tools in China.

Short sellers are starting to cover their bets and some investors see opportunities and so are tip-toeing back into the battered bonds.

Agile Property Holdings shares have fallen 45 percent so far in 2011. A Thomson Reuters Starmine model that determines the equity market's view of credit risk gives it a BB+ rating.

That is four notches below another Starmine model that assigns a rating based on forward-looking credit fundamentals - the biggest gap among Hong Kong-listed Chinese real estate companies - suggesting the stock's selloff may be overdone.

China Construction Bank's rating based on its equity performance is five notches below its fundamentals-based rating.

The divergence combined with a forward 12-months earnings multiple that Starmine shows is 53 percent below a long-term average, suggests the shares are oversold.

Without any foreign debt exposure and the world's biggest stockpiles of currency reserves, China has the ability to print yuan and repair local government and state-owned bank balance sheets. In a world of significant sovereign credit risks, China is not one to worry about.