China paves way for credit default swaps as government girds for more defaults

By: | Published: June 2, 2016 2:38 PM

A Chinese financial committee has proposed new rules for hedging defaults, sources said Thursday, as Beijing aims to buttress financial markets and banks against a surge of bond defaults.

china financial marketThe committee met recently to amend rules governing the rarely used credit risk mitigation (CRM) market, the only bond default hedging tool in China at present .(Reuters)

A Chinese financial committee has proposed new rules for hedging  defaults, sources said Thursday, as Beijing aims to buttress financial markets and banks against a surge of bond defaults.

China will move closer to launching credit-default swaps (CDS) for the first time under the recommendations, which were made by the financial derivative committee under the state-controlled National Association of Financial Market Institutional Investors (NAFMII), the sources said.

The committee met recently to amend rules governing the rarely used credit risk mitigation (CRM) market, the only bond default hedging tool in China at present, the sources with direct knowledge of the matter told Reuters.

“The government has now made it very clear that everyone won’t be bailed out,” said Saifeng Mao, Associate Director at Fitch Ratings in Hong Kong.

“This is helping prepare the market for more defaults, and allowing market forces to play a stronger role in pricing. A few months ago corporate spreads were very compressed, meaning the market didn’t really know how to price a lot of bonds, and that’s looking better now.”

The proposed new rules include guidelines for trading CDS and credit-linked notes (CLN), signalling intentions to offer the products in China for the first time, the sources said.

They will need approval from the executive conference of NAFMII, which is entrusted by China’s central bank to supervise issuance of corporate notes. NAFMII had no immediate comment.

For years, China’s now $7.5 trillion bond market has worked on the assumption that the government would not allow a default. Issuers were effectively guaranteed by the state.

But while China has cautiously allowed some defaults since 2014, doubts remain as to how far it will go given that many issuers are state-linked and the risk of a bond market crash – which analysts say would have a much bigger impact than China’s stock market slump last year.

In April, Chinese bonds sold off sharply following a series of defaults by state-backed firms such as steelmaker Dongbei Special Steel Group Co Ltd and tough statements by the central bank on curbing support for loss-making “zombie” enterprises.

A Reuters analysis of central bank data shows that firms in regions heavily exposed to legacy industries such as coal and steel showed sharply rising dependence on expensive “shadow finance” in the first quarter as traditional lenders withdrew.

Chinese firms cancelled or delayed over $15 billion of bond issuance in April.

MORE PROTECTION
A CDS, typically used in developed markets, is a financial swap agreement under which the seller of the CDS will compensate the buyer in the event of a default or other credit event.

The proposed new rules will permit investors in the product to include in their agreements compensation for different degrees of credit risk, such as restructuring, the sources said.

A CLN is a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors, while the issuer is not obligated to repay the debt if a specified event occurs.

The new rules will allow CDS and CLN to co-exist with China’s existing CRM market, which has been rarely used since it was set up in 2010 given a lack of defaults.

NAFMII has been considering setting up a CDS and CLN market since December.

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