How China is relaunching credit risk hedging tools
1. What is happening in the Chinese real estate market?
Construction and real estate sales have been the main drivers of economic growth since President Xi Jinping came to power nearly a decade ago. Home prices soared as an emerging middle class flocked to real estate. The boom led to speculative buying as new homes were pre-sold by property developers who increasingly looked to foreign investors for funds. In 2020, China tightened funding rules for developers to crack down on reckless borrowing, fearing a meltdown could undermine the financial system. But many developers didn’t have enough cash on hand to cover their debts. A sales slump that began during the pandemic has been compounded by aggressive measures to contain Covid-19, deepening the liquidity crunch. A default last year in one of the largest groups, China Evergrande Group, shocked the market (China only started letting companies default on bonds in 2014). The ripple effects have affected other private developers, including Sunac China Holdings Ltd. in May. As of June 1, every failed Chinese company in 2022 was a developer, except for E-House China Enterprise Holdings Ltd., which provides real estate services.
2. Why do you need credit risk hedging tools?
Private companies are still facing a cash crunch due to falling new home sales, while high interest rates have closed the offshore bond market to many builders. Regulatory measures have mainly targeted top-rated companies, with disappointing results. For example, attempts to encourage banks to increase their support for mergers and acquisitions in the real estate sector met with little support. A similar crisis in 2018 prompted Chinese regulators to reinvigorate their efforts to provide investors with ways to hedge risk. Now they are again promoting the use of such tools as a way to restore confidence and help private companies raise funds in the bond market, according to the official Shanghai Securities Journal.
Credit default swaps (CDS), which allow traders to bet on the creditworthiness of a company or group of companies, have been around for decades in developed markets but are little used in China. Instead, credit risk mitigation warrants (CRMWs) are the most common hedging tools. Although widely known as Chinese CDS, the instrument is not exactly that. A CRMW provides default insurance tied to a specific bond or loan obligation, while a CDS (introduced by China in 2016) can be tied to an issuer or its various debts. The Shenzhen Stock Exchange added to the arsenal in May with so-called credit protection mandates for private developers, which have the same goal of boosting investor confidence.
4. Who uses them?
Private developers, including Longfor Group, Seazen, Midea Real Estate and Country Garden, have been at the forefront this year of selling domestic bonds protected by risk-hedging derivatives, signaling regulatory support. A June 1 report from S&P Global Ratings called the guarantees “tokenistic in that they only cover a portion of transactions.” But he said such support “could turn out to be significant” if investors saw it as “validation” of which developers are in the best position. As of June 1, 54.8 billion yuan ($8.2 billion) of CRMW had been sold in the interbank market since 2018, according to data compiled by Bloomberg. They are growing in popularity – 20.5 billion yuan of CRMW was sold in 2021, compared to 11.6 billion yuan in 2020. But this is still a small amount compared to China’s onshore bond market, which is valued at 138 .2 trillion yuan according to data from the People’s Bank of China.
Seller. There are 34 CRMW issuers, with China Zheshang Bank Co., China Bond Insurance Co. Ltd. and Bank of Communications Co. topped the list, according to data compiled by Bloomberg. Most are state-owned banks and brokerage firms, with the exception of China Bond Insurance, which is a state-backed specialty company. Dealers must be licensed by their self-regulatory body, the National Association of Capital Markets Institutional Investors, and there are 125 dealers. Fees charged by CRMW providers, which are almost like an insurance premium, range from 0.1% to 4.1%, according to data compiled by Bloomberg.
6. How effective are they?
Unknown. By early June, there had been no defaults on any of the 346 onshore notes CRMW protected to provide a test case, according to data compiled by Bloomberg. This is primarily because issuers who are able to sell bonds with default insurance already almost invariably have more secure credit ratings and are therefore less likely to run into trouble. Better quality developers may be able to use them to secure onshore financing when most other financing channels remain closed, but they are of little help to struggling builders. Hedging tools for the riskiest borrowers remain a rarity, leaving investors exposed.
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