Regulator opts for caution as credit default swap trading starts

China started trading in credit default swaps this week, with analysts saying that it remains to be seen whether the new hedging tool would help investors deal with the rising risk of corporate defaults as the economy slows down.

A total of 15 CDS transactions were conducted in the interbank market with total 300 million yuan ($44.4 million) of notional principal on Monday, according to a statement on the website of the National Association of Financial Market Institutional Investors, a unit under the People's Bank of China.

Ten Chinese financial institutions, including the country's four biggest banks, participated in the trading of the first batch of CDS.

The transactions covered sectors including oil, electricity, water, coal, telecommunications, food and aviation. The underlying assets for these CDS were bonds issued by companies with an AAA rating.

Industry analysts said that starting the CDS trading with AAA-rated companies shows the regulator has adopted a cautious approach to test the market, intending to ensure a smooth introduction of the risk-hedging tool.

"The CDS price of AAA-rated companies will be stable, which can help ensure a stable market," said Liu Dongliang, a senior analyst at China Merchants Bank Co Ltd.

The Chinese regulator in September approved the trading of CDS, a financial swap agreement that allows buyers of CDS to be compensated by the swap sellers in the event of a loan default.

The move is seen as consistent with the government's intention to increase the use of market forces to address China's debt problem, instead of resorting to a government bailout when credit defaults take place.

There has been a rising demand by Chinese investors to hedge the rising risk of corporate failure to repay debts, amid the economic slowdown.

Nomura Securities estimates that China's non-financial sector debt stood at 158.5 trillion yuan, or 231 percent of GDP by end of last year. A large share of the debt was owed by the corporate sector, in particular the State-owned enterprises, while government debt is relatively low.

"The introduction of the CDS helps improve China's financial market with greater ability to price risk. We will inevitably see more debt defaults. So there is an urgent need in the market for such a tool," said Zhao Yang, chief China economist at Nomura Securities.

Orderly defaults, shifting the SOE debt to the government and continuous financial reforms will help address China's debt problem, Zhao said, adding that policy has to head toward lower interest rates and a weaker currency at the macroeconomic level.