China Plans to Introduce Credit-Default Swaps by Year-End, Official Says

China will introduce credit-default swaps by year-end, allowing banks to hedge risk while restricting the contracts to avoid pitfalls the U.S. credit markets experienced over the last several years, according to an official with a state-backed Chinese financial association.

China will limit the amount of leverage used in credit swaps and won’t permit the contracts to be written on high-risk assets such as subprime mortgages, Shi Wenchao, secretary general of the National Association of Financial Market Institutional Investors, told reporters at a briefing in New York. Investors in the derivatives will also be required to own the underlying security, Shi said.

“It’s too bad that we in America and in Europe did not have those kinds of limitations two or three years ago,” Donald Straszheim, International Strategy & Investment Group’s head of China research, said in a telephone interview from Los Angeles. “All of us around the world might be in a lot better shape than we are now. What’s most important is that their plans are to not allow this whole process to get out of control.”

Private swaps complicated efforts to solve the credit crisis in the U.S. when regulators and market users couldn’t easily determine how interconnected banks had become through trading contracts. American International Group Inc. needed a U.S. bailout that swelled to $182.3 billion after losses fueled by a unit that sold guarantees on mortgage-linked debt to banks including Goldman Sachs Group Inc.

‘Neither Evil Nor Good’

“We believe CDS is a neutral risk-management tool,” said Shi, whose group monitors the country’s interbank market and promotes innovation in financial products. “It is neither evil nor good.”

China plans to introduce credit derivatives to help manage risk in the nation’s growing domestic bond market, he said at a June briefing in Beijing.

Sales of yuan-denominated corporate bonds in China jumped to 496 billion yuan ($74 billion) last year from 7.9 billion yuan in 2000, according to data compiled by Bloomberg. The global credit-default swap market is now $25 trillion after reaching $62 trillion in 2007 before the financial crisis. Credit-default swaps are derivatives that pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

“CDS in China is a management tool,” Shi said. “There will be no repackaging or restructuring of risk.”

Universe Increases

“Development of a Chinese domestic credit-default swap market is positive in increasing the universe of credit risk management tools,” Keith Noyes, the International Swaps and Derivatives Association’s Asia-Pacific director, said in response to e-mailed questions. “However, it is unclear how the introduction of CDS would fit in with the current draft China Banking Regulatory Commission regulations.”

The People’s Bank of China formed NAFMII in 2007 to help develop the country’s over-the-counter financial markets, which span bonds, loans, foreign exchange, commercial paper and gold.

China expects to further open its debt markets, with the prospects for foreign companies selling debt in China improving from “promising” to “extraordinarily great” in three to 10 years, Shi said. China pledged to treat foreign companies in the same way as its own when it was admitted to the World Trade Organization in 2001.

McDonald’s Yuan Bonds

In August, McDonald’s Corp. became the first foreign company to sell yuan-denominated bonds in Hong Kong with a 200 million yuan issue. Wal-Mart Stores Inc., based in Bentonville, Arkansas, said in March it was considering an offering.

Overseas firms remain restricted from selling yuan- denominated notes in mainland China, five years after the Asian Development Bank and International Finance Corp., both supranational agencies, sold the first so-called Panda bonds.

NAFMII said in December that Asian companies may be allowed to start sales this year. Bank of Tokyo-Mitsubishi UFJ (China) Ltd. became the first foreign bank subsidiary to sell the bonds in China in May, issuing 1 billion yuan of two-year notes.

The Chinese bond market also remains largely closed to foreign investors. Plans to open the market to overseas buyers, such as U.S. pension funds, will require further study, Shi said.

NAFMII officials are in New York meeting with firms including Citigroup Inc. and JPMorgan Chase & Co. about the asset-backed securities market, Shi said. The group also met with financial firms in Germany and Poland to discuss securitization, he said.

Chinese officials began discussions with bankers several years ago to learn about securitization, he said. In 2007, AAA rated securities backed by home loans tumbled in value with the onset of the subprime mortgage crisis, leading to $1.8 trillion of losses worldwide.

“We learned from the U.K., Europe and the U.S.,” Shi said. “But we did find that there were problems with some of the teachers.”

To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net Shelley Smith in Hong Kong at ssmith118@bloomberg.net

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