Photographer: Qilai Shen/Bloomberg

Why China's Latest 'Financial Innovation' Might Not Work

Goldman Sachs asks a tough question about the credit default swaps introduced in the country this week.

Behold, the latest in Chinese financial innovation.

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That's a statement published this week by the National Association of Financial Market Institutional Investors. It heralds the start of trading, in China, of credit-default swaps (CDS), or derivatives used by investors to protect against default by companies and other entities. It says that 10 institutions, including China's four biggest banks, have on Oct. 31 conducted 15 CDS transactions totaling 300 million yuan ($44.4 million) of notional principal across a bevy of companies related to gas, electricity, coal, and aviation, among others.

The introduction of credit default swaps comes as Chinese Premier Li Keqiang promises to weed out zombie companies in an effort to improve confidence in China's economy. With corporate defaults in the country beginning to rise — albeit from ultra-low levels — the use of CDS can help investors protect their portfolios from soured bond deals.

Setting aside the question of whether these new instruments will be deployed in large enough sums to make a difference to investors, there are other looming problems. For instance, there is a thorny issue highlighted by a recent note from Goldman Sachs Group Inc.

Just who, asks Goldman Analyst Kenneth Ho, is selling CDS protection on Chinese corporates?

Credit-default swaps represent a binary bet on a company's creditworthiness, with the buyer of protection paying premiums to a protection-seller in return for an insurance-like payout should the bonds sour. In the event of a dramatic increase in Chinese corporate defaults, protection sellers could be on the hook for significant payouts. And while the Chinese government is clearly keen on transferring credit risk through the use of such instruments, one wonders just who they are transferring risk to.

"Although such products will provide lenders with a tool to hedge their credit exposures by purchasing CDS protection, it is unclear who will be the seller of the protection, and if the sellers are other financial institutions, the credit risks are merely transferred to other parts of the financial sector," writes Ho.

Credit-default swaps are the latest in a string of Chinese financial innovation with previous examples including packaging up non-performing loans (NPLs) into bonds that can be sold to investors as well as debt-for-equity swaps — all of which are aimed at managing the risks of corporate indebtedness, and none of which have so far impressed Goldman.

"To us, there are two concerns surrounding these new financial products," writes Ho. "First, while these new products provide channels for risks to be transferred, they may not ultimately resolve the underlying credit problems. Second, the size of these transactions may not be large enough to provide comprehensive solutions." 

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