China Moves Toward Launching Credit-Default-Swap Market

China’s interbank-market regulator is likely to seek approval from China’s central bank to launch a CDS market soon

The National Association of Financial Market Institutional Investors is likely to ask the People’s Bank of China for formal approval to launch a CDS market soon

China is edging closer to launching its own version of a popular hedging tool that protects investors in case of defaults, as the world’s No. 2 economy struggles to cope with slowing growth and record numbers of companies not paying back debt.

The National Association of Financial Market Institutional Investors, an industry body backed by China’s central bank, has consulted major banks and brokerage firms in recent weeks about the planned rollout of credit-default swaps, three people familiar with the situation said. The swaps would pay out if the issuer of a bond or a loan defaults, said the people, who were briefed by the regulator on the matter.

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The regulator, which oversees China’s $8.5 trillion interbank bond market, has drafted guidelines and standardized contracts for the product, one that has in the past two decades become a key tool in global markets to hedge government and corporate debt, the people said.

NAFMII has hired a group of lawyers to help align its CDS rules with internationally accepted practices and is expected to ask the People’s Bank of China for formal approval to launch the market soon, one of the people said.

Officials at NAFMII weren’t reachable for comment.

The planned rollout of rules for CDS reflects the pressures China faces as it tries to attract more investors, including global players, to a swelling bond market, even as debt defaults soar. China’s domestic bond market has had 39 defaults totaling around 25 billion yuan ($3.8 billion) this year, already exceeding the total of 20 defaults worth 12 billion yuan for all of last year. In 2014, there were five such defaults, following one in 2013.

 “If the [CDS plan] is carried out well in China, it will certainly be a big help to investors,” saidWang Ming, a partner at Shanghai Yaozhi Asset Management Co., a bond fund that manages two billion yuan in assets.

China experimented with a less sophisticated version of a CDS called a credit-risk-mitigation agreement, or CRMA, in 2010, in the wake of a credit binge. But the CRMA market never took off, because the state kept bailing out insolvent companies instead of letting them default, in the interests of financial and social stability.

Now, there are signs that Beijing and the country’s local governments are becoming more tolerant of debt defaults as the economy weakens further and governments feel increased fiscal strains.

“The timing is indeed better now for CDS to be introduced to China. Given that all kinds of defaults are on the rise, I think demand will be quite robust,” Mr. Wang said.

The guidelines and standardized contracts for the credit derivative drafted by NAFMII look to be in line with those published by the International Swaps and Derivatives Association, a global body based in New York that sets standard terms for derivatives transactions, said one of the people briefed on the instruments.

So great is the enthusiasm for CDS in China that some officials seem to view them as a way to help ailing companies get credit. The government of the northern province of Shanxi, China’s biggest coal-producing region, said it hopes to encourage credit-default swaps as a means to raise investor confidence in debt issued by the area’s struggling coal-mining firms. Typically big coal miners are backed by the state.

According to a front-page article published Thursday in the Shanxi Daily, the Communist Party’s local mouthpiece, companies from the region are facing greater difficulties in issuing new debt because of a weakening economy and rising debt defaults among state-run enterprises.

One of the coal-mining firms from the province that is struggling to meet its debt repayment, state-backed ChinaCoal Group Shanxi Huayu Energy Co., defaulted on a 600 million yuan one-year bond in April.

“We’ve already come up with a plan, and Shanxi would like to become the first local government to roll out a CDS contract in China,” said Liu Hongbo, an official at the financial affairs office of the Shanxi provincial government.

CDS are normally created by investment banks, which calculate the default risks involved and charge sometimes steep fees for the guarantees, and it is unclear how Shanxi province proposes to handle them.