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September 24, 2016

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New rules on China’s credit default swaps

NEW rules published in China yesterday on credit default swaps were met with skepticism about how effective the hedging tool would be in addressing the country’s growing debt risks.

The market provides insurance against debt defaults and is the latest indication of China moving to find tools to help manage what the IMF has described as an “unsustainable” rise in credit.

The rules were published on the website of the National Association of Financial Market Institutional Investors (NAFMII), which supervises the issuance of commercial paper and some other types of debt in China’s interbank bond market.

Investors said credit default swaps (CDS) could help bond investors better manage risks. But they questioned how effective or popular they would be when defaults are still rare, legal frameworks are largely untested and other Asian markets already struggle for liquidity.

Widespread pricing distortions in China’s bond market mean risk premiums between higher and lower-rated corporate bonds are narrow, which in turn makes it difficult to effectively price CDS, these investors said.

“This is a really big market, there will always be some people who are interested in protection,” said a Singapore-based portfolio manager who invests in Chinese onshore debt, but who declined to be identified in the absence of authority to speak to the media. “But foreign investors will want to know what the legal framework is, who the market makers are, etc.”

Thomas Drissner, investment manager at Aberdeen Asset Management in Singapore, said the Asian dollar bond market lacked the liquidity to hedge credit risk efficiently.

“Hence, I have my reservations what liquidity in a yuan instrument will look like. Hedging only makes sense if you can trade in and out whenever you want,” Drissner said.

“You have to have a very strong view to make this work from an economic point of view,” he said.

Integration with other CDS markets will be difficult because of different documentation and laws, cutting off another avenue of potential liquidity, said Keith Noyes, Asia director at International Swaps and Derivatives Association, a global derivatives trade body that sets industry standards for the biggest CDS markets. “That makes standardization and product fungibility difficult,” he said. “Its prospects would be enhanced by integration and access to offshore liquidity. That is constrained by differences in documentation and choice of law.”

NAFMII had no immediate comment.

China has cautiously allowed some bond issuers to default since 2014, although doubts remain about how far the government is really willing to go when so many companies are state-linked and when policy-makers are highly sensitive to the risk of financial instability.

But China’s debt load has ballooned since the global financial crisis to sit around 250 percent of GDP. The central bank and some international authorities, including the IMF, have raised concerns about the fast pace of growth in corporate credit in particular.

The CDS market is one option put forward to help investors hedge against debt risk. Others include securitizing bad debt and swapping non-performing loans for equity.

The formal launch of CDS has been in the works for a while, but gained steam earlier this year when stresses in the nation’s corporate bond market led to a sharp sell-off in April and in turn prompted firms to delay or cancel over US$15 billion of new bond financing that month.

Earlier this month, China Securities sold credit protection for the senior tranche of Agricultural Bank of China’s recent securitization of non-performing loans.


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