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Credit Swaps on Chinese Debt Surge on Slowdown Fears

Fears of an economic slowdown in China have fuelled a trading surge in instruments that insure investors against sovereign bond defaults, making the country a new focal point for the widely used financial products.

Shanghai
Photo by: Cory Doctorow
Shanghai

The net value of outstanding credit default swaps on Chinese sovereign debt has soared to $8.3 billion, according to data released this week by The Depository Trust and Clearing Corporation.

The market for China CDS is now the world’s 10th largest, bigger than those for Portugal and Bank of America. Two years ago there was a net $1.6 billion of outstanding China CDS, making it only the world’s 227th largest at the time.

“Clearly there is increasing market concern about China and a few cracks are starting to appear in its economic growth,” said Ann Wyman, head of emerging market research at Nomura. “A ‘hard landing’ still isn’t our house base case scenario, but we’re more concerned about this than we have been in the past.”

Prominent hedge fund managers such as James Chanos and Hugh Hendry have frequently and publicly predicted a property crash and sharp economic slowdown in China, and have launched funds dedicated to profit from this.

Mr Hendry’s fund, Eclectica Credit Fund, has notched up significant gains over the past two months, even as many industry peers have suffered losses due to the recent financial turmoil.

While China’s sovereign debt is still considered as among the safest in the world, the price of China CDS hit a two-year high of 208 basis points this week, according to Markit. On Wednesday the cost of China CDS fell to 187 bps. That means it costs the equivalent of $187,000 annually to insure $10 million for five years.

Analysts say the increase in demand and cost for China CDS is related to recently heightened worries about ability of the authorities to orchestrate a soft landing after years of red-hot economic growth.

Soaring housing prices from late 2008 to 2010 in particular have prompted fears that a property bubble could burst, with severe negative effects for the wider economy.

The authorities have responded by raising mandatory mortgage downpayments, ordering banks to lend less to developers and tightening monetary policy. Wilting growth in Europe, a key export market for China, has recently exacerbated concerns.

“The authorities are now faced with a difficult decision on whether to pursue monetary tightening amid global economic headwinds. September inflation data will probably dictate the next steps for policymakers,” said Alex Hamilton, an economist at Markit, the data provider.