How China Revives Credit Risk Hedging Tools

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As regulators clamped down on excessive borrowing by China’s real estate developers, the fallout from a resulting liquidity squeeze has weighed on an economy already struggling from pandemic lockdowns and other disruptions. So regulators have returned to a tool they used to try to restore domestic investor confidence the last time the onshore credit market struggled: derivatives, which hedge risk against default. The reaction was limited, however, as bond issuance by home builders from June had its slowest start to the year since 2015 – highlighting the scale of the challenge to calm markets this time.

1. What is happening in the Chinese real estate market?

Since President Xi Jinping took office almost a decade ago, construction and real estate sales have been the biggest engines of economic growth. Real estate prices have skyrocketed as a burgeoning middle class flocked to real estate. The boom led to speculative buying as new homes were pre-sold by developers who increasingly turned to foreign investors for funds. In 2020, China tightened funding rules for developers to crack down on reckless borrowing, fearing a collapse could undermine the financial system. But many developers didn’t have enough cash to cover their liabilities. A slump in sales that began during the pandemic was deepened by aggressive measures to contain Covid-19 and exacerbated the liquidity crisis. A default last year at one of the largest, China Evergrande Group, rocked the market (China only started defaulting on corporate bonds in 2014). The domino effects have hit other developers, including Sunac China Holdings Ltd. in May. As of June 1, every Chinese company that defaults in 2022 is a developer, except for E-House China Enterprise Holdings Ltd., which provides real estate services.

2. How do credit risk hedging tools help?

Companies are still facing a liquidity crunch as new home sales plummet, while high interest rates have closed the offshore bond market to many builders. Domestic stock and bond investors have also shunned stressed developers, particularly those privately held. A similar crisis in 2018 prompted Chinese regulators to redouble their efforts to provide investors with avenues for risk hedging. Now authorities are once again encouraging the use of such tools to restore confidence and encourage investors to subscribe to issues they might otherwise have avoided.

Credit default swaps (CDS), which allow traders to place bets on the creditworthiness of a company or group of companies, have been around in developed markets for decades. Nevertheless, such securities are hardly used in China. Instead, credit risk mitigation warrants (CRMW) are the most commonly used hedging instruments. While the instrument is widely known as China’s CDS, it’s not exactly that. A CRMW provides insurance against default linked to a specific bond or loan obligation, while a CDS, which China launched in 2016, can be linked to an issuer or its various debts can.

4. Who uses them?

Private developers such as Longfor Group, Seazen, Midea Real Estate and Country Garden have been at the forefront of selling domestic bonds protected by risk hedging derivatives this year, indicating regulatory support. As of June 1, 54.8 billion yuan ($8.2 billion) of CRMW has been sold on the interbank market since 2018, data compiled by Bloomberg shows. That’s a tiny amount compared to China’s onshore bond market worth 138.2 trillion yuan, according to data from the People’s Bank of China.

The seller. There are 34 issuers of CRMW, with China Zheshang Bank Co., China Bond Insurance Co. Ltd. and Bank of Communications Co. top the list, according to data compiled by Bloomberg. Most are state-owned banks and brokerage firms, with the exception of China Bond Insurance, a state-backed, specialized company. Dealers must be licensed by their self-regulatory organization, the National Association of Financial Market Institutional Investors, and there are 125 dealers. Fees charged by CRMW providers, which are almost the equivalent of an insurance premium, range from 0.1% to 4.1%, according to data from Bloomberg.

6. How effective are they?

Unknown. As of early June, none of the 346 onshore debt securities protected by CRMW had a default, according to data compiled by Bloomberg to provide a test case. This is mainly because issuers that can sell bonds with default insurance almost always already have safer credit ratings and are therefore less likely to get into trouble. More skilled developers may be able to use them to secure onshore financing when most other funding channels remain closed, but they’re of little help to the deeply desperate builders. Hedging instruments for the riskiest borrowers remain a rarity, leaving investors exposed.

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