Credit default swaps are storing up trouble for China

Joe Zhang
Qilai Shen | Bloomberg | Getty Images

Credit default swaps are a Wall Street invention. During the crisis of 2008, they crippled a number of significant financial companies. But where in the world are such instruments most popular? Not in the US, despite what you might think, but in China.

The China Financing Guarantee Association, a quasi-governmental body that regulates the guarantee companies (in other words, the issuers of the swaps), says it has 194 member institutions, though their ranks have thinned in recent years. Many guarantee companies have simply not bothered to become members of this club.

In a parallel with the American obsession with home ownership that led to the formation of Fannie Mae and Freddie Mac, the federal housing finance agencies, the Chinese government has in the past few decades done its best to promote small and medium-sized enterprises by providing them with credit guarantees. Tens of thousands of state-owned, private and hybrid guarantee companies have come into being.

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And just like Fannie Mae and Freddie Mac, China's guarantee companies are all thinly capitalised. This is due partly to the misconception that a third-party guarantee is sufficient for SMEs to tap commercial credit.

Mispricing in China's CDS market is severe and chronic. The guarantee companies typically charge only 2-3 per cent to the borrowers, but assume the full risk of their loan delinquency. When the economy was growing fast, from the 1980s through to the early 2010s, these guarantee fees seemed like manna from heaven — so much free money. But when the economy began to slow from 2012 onwards, default rates rose, and many guarantee companies disappeared.

Only then did people begin to question the business model and the pricing of guarantees. However, nobody seems to know how to correct the problem of mispricing.

Unlike CDS in the US, credit guarantees in China have the following deficiency: usually, they cannot be traded. Some observers argue this is probably an advantage for the industry because it forces deal originators to "eat what they cook", minimising irresponsibility and recklessness in their origination process.

It is estimated that the total size of China's market for such instruments is more than $500bn, excluding the credit enhancement these guarantee companies provide to SMEs' bond sales and asset-backed securities. But no one knows the size of the market for sure.

The number of guarantee companies still operating has reduced significantly since the peak in 2011. Today, their main mission is to unwind their long-duration guarantees and liquidate the collaterals they have repossessed — dubious equity stakes here and there, land or real estate. There are some healthy operators, but they are few and far between.

Why should this story be of interest to the Chinese public and, indeed, to outside observers? Because it is key to understanding the strange longevity of China's credit bubble.

It is true that the country's credit market is far too big, but against the doomsday scenarios some analysts have painted, it has refused to burst because of the many non-bank financial institutions that have served as plumbers for the banks.

China's economic slowdown in the past five years has decimated its microcredit sector and, to a lesser extent, the trust companies. Their destruction has also helped shield the commercial banks.

As one grateful commercial banker recently remarked to me, CDS, bridge loans and wealth management products have served as the banks' sewage pipes. Half-jokingly, he described the CDS issuers as "selfless and heroic".

The writer is the chairman of China Smartpay Group and a former manager at the People's Bank of China

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