November 1, 2016 / 9:35 AM / a year ago

UPDATE 1-China conducts first batch of credit default swap transactions

* Inaugural batch of CDS contracts worth 300 mln yuan executed

* Credit differentiation has reduced since the start of the year

* CDS launch amid soaring debt load in China (Adds context, details, quotes)

HONG KONG/BEIJING, Nov 1 (Reuters) - China launched this week its first credit default swaps, a kind of insurance for investors against bond defaults, marking another step in Beijing’s efforts to address the country’s growing debt risks.

Ten financial institutions conducted 15 credit default swap (CDS) transactions on Oct. 31, the first such transactions in China’s interbank market, a Chinese bond supervisory body said on Tuesday.

The 15 transactions totalled 300 million yuan ($44.28 million) in nominal principal, the National Association of Financial Market Institutional Investors (NAFMII) said in a statement on its website.

“Tools like CDS and IRS (interest rate swaps) are important to development of capital markets in general and fixed income in particular. It is critical to driving bond market liquidity and it is a welcome development,” said Mark Austen, Hong Kong-based CEO of ASIFMA, a securities industry body.

Austen said the lesson to learn from the experience of international markets is not to have derivatives markets overly complicated with the use of complex products.

“They should make the products easy to understand and avoid situations like in the financial crisis where many did not even know the level of their exposure to Lehman Brothers.”

China’s debt load has soared since the 2008/09 global financial crisis as companies borrowed heavily to sustain growth. As a result, corporate borrowings are now $18 trillion or 169 percent of GDP.

The government has cautiously allowed some bond issuers to default since 2014, although doubts remain about how far the government is really willing to go when so many companies are state linked and when policymakers are highly sensitive to the risk of financial instability.

NAFMII did not name the companies for which CDSs were traded on Monday.

Ying Wang, Fitch’s senior director based in Shanghai, said the trading probably did not reflect worries about underlying creditworthiness of the firms.

“This is more likely to be a test of the new CDS scheme rather than concerns over (specific) credit risk. SOEs are usually the first batch of candidates to participate in new regulatory tools,” Wang said.

Widespread pricing distortions in China’s bond market mean risk premiums between higher- and lower-rated corporate bonds are narrow, which in turn makes it difficult to effectively price CDS, analysts said.

Credit differentiation in China’s $7.5 trillion bond market has diminished as the pace of defaults has slowed. Goldman Sachs estimated there was only one default in the domestic Chinese bond market in the third quarter, compared with at least 10 in the first half of the year.

This view was already reflected in the market. Since the pace of defaults has slowed, the yield gap between the AAA-rated 5-year corporate bond benchmark and the AA-rated comparable has dropped to 40 basis points (bps) from over 70 bps in mid-2016.

$1 = 6.7754 Chinese yuan Reporting by Beijing Monitoring Desk and Umesh Desai in HONG KONG; Writing by John Ruwitch; Editing by Jacqueline Wong

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