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China looks at ways to hedge debt risks as defaults rise: sources
[SHANGHAI] In a sign China is exploring ways to allow more bond defaults without destabilising the market, a state body has circulated plans to introduce credit-default swaps (CDS) and other derivatives, sources said, so investors can hedge risk in its US$7.5 trillion bond market.
For years, China's bond market has worked on the assumption that the government would not allow a default. Issuers were effectively guaranteed by the state.
Since 2014 though, China has cautiously allowed some bond issuers to default although doubts remain as to how far the government is willing to go given that many issuers are state-linked and the risk to stability if the bond market crashes - which analysts say would have a much bigger impact than China's stock market slump last year.
China needs a healthy bond market as an alternative to bank lending, especially as bonds are better suited to funding projects of specific lengths and can be more easily traded in the secondary market than loans. But widespread pricing distortions in which high-risk debt trades near risk-free rates worry analysts.
The industrial sectors that China has targetted for downsizing to tackle surplus capacity are also the ones that produced the most defaults in 2015, official data shows. Coal, steel, chemicals and non-metallic minerals accounted for over a quarter of total outstanding liabilities in the industrial sector as a whole at the end of 2015, the data shows.
That raises questions about how far Beijing can push industrial restructuring without undermining the stability of the banking system and debt markets. "I think people have been waiting for this for a long time, but it's difficult in China to wind this stuff up in practice,"said Tim Condon, ING chief Asia economist in Singapore. "The authorities are aware that you can't have a financial crisis turn into a bank run, so in the event of a really serious issue I suspect that the first round of defence would be to throw money at the problem."
Sources said China's National Association of Financial Market Institutional Investors (NAFMII), a state-controlled body, has been considering setting up a CDS market since December. NAFMII declined to comment.
Its latest idea to use CDS, an insurance policy against debt defaults used in developed markets, and credit-linked notes (CLNs) would replace NAFMII's credit risk mitigation market, which was rarely used since it was set up in 2010 given a lack of defaults. "We really need effective derivative tools for risk management and diversification," said one person who attended a meeting in December organised by NAFMII to discuss the plan. "The zero default policy has been broken," said this person.
The CDS proposal is another indication of how China is slowly moving to offset some of the risks of massive debts in the economy. It is running a pilot programme on securitising bad debt, is considering a plan to let banks swap non-performing loans for equity stakes and has made it easier for foreigners to access its bond market.
Stress on corporate balance sheets is clear. With more cash tied up in inventories and unpaid bills, they are facing their tightest liquidity crunch in a decade, a Reuters analysis shows.
Yields on a handful of low-rated bonds spiked this week after steelmaker and state-owned enterprise (SOE) Dongbei Special Steel Group Co Ltd missed a payment on short-term commercial paper.
Financial magazine Caixin reported this month that Tianjin-based Bohai Steel Group Co Ltd may be unable to make full repayment on 192 billion yuan of debt. "The fact that (Dongbei Special Steel Group) was the first locally administered SOE to have defaulted despite the underwriter being a policy bank is having a psychological impact on the onshore bond market," said Xie Dongming, China analyst at OCBC Bank in Hong Kong. "We did not see any last minute rescue and points to reduced ability and willingness of the local government to intervene. This is like opening the Pandora's box - nobody is safe. We can see more defaults coming." The rising concerns over company debt come after corporate bonds have rallied to levels that analysts see as a possible sign of bubbly market conditions given the rising level of indebtedness and defaults.
High-yield corporate debt sold off sharply in late 2015 amid rising defaults and concerns over the ability of the central bank to keep easing policy without further pressuring the yuan.
But as capital outflows from China ebbed this year and the central bank resumed its policy easing campaign, investors returned.
The risk premium of AA-rated 5-year corporate debt over equal-tenor treasuries has fallen by more than 100 basis points to 4-year lows.
While Beijing remains broadly committed to the principle of reducing debt levels, many insiders say that in practice the government is going to prioritise economic growth over reform until wider economic conditions - in particular demand - stabilise. "There is room for us to lower leverage," said an influential economist at the Development Research Centre, the cabinet's think-tank. The economist declined to be identified. "But if conditions are not ready and we hastily and quickly reduce leverage, it could trigger some risks."