As regulators have cracked down on excessive borrowing by China’s property developers, the fallout from a resulting liquidity squeeze has weighed on an economy already struggling due to pandemic lockdowns and other disruptions. So regulators have returned to a tool they used to try to restore domestic investor confidence the last time the onshore credit market ran into trouble: derivatives that hedge risks against default. The response has been limited, however, with bond issuance by private-sector builders as of June off to its slowest annual start since 2015 -- illustrating the extent of the challenge to reassure markets this time.
1. What is going on in China’s property market?
Construction and property sales have been the biggest engines of economic growth since President Xi Jinping came to office almost a decade ago. Home prices have skyrocketed as an emerging middle class flocked to property. The boom led to speculative buying as new homes were pre-sold by property developers who turned more and more to foreign investors for funds. In 2020 China tightened financing rules for developers to crack down on reckless borrowing, fearful that a collapse could undermine the financial system. But many developers didn’t have enough available cash to cover their liabilities. A sales slump that began during the pandemic was deepened by aggressive measures to contain Covid-19, aggravating the liquidity crisis. A default last year at one of the biggest, China Evergrande Group, shocked the market (China only started letting companies default on bonds in 2014). The ripple effects have hit other developers, including Sunac China Holdings Ltd. in May. As of June 1, every Chinese firm defaulting in 2022 has been a developer except for E-House China Enterprise Holdings Ltd., which provides real estate services.
2. How do credit risk hedging tools help?
Companies are still facing a cash crunch because of slumping new home sales, while high interest rates have closed off the offshore bond market to many builders. Domestic stock and bond investors have shunned stressed developers as well, especially the privately owned ones. A similar crisis in 2018 spurred China’s regulators to re-energize efforts to provide investors with ways of hedging risk. Now authorities are again encouraging the use of such tools as a way to restore confidence and incentivize investors to subscribe to issuances that they might otherwise have shunned.
3. What’s available?
Credit-default swaps (CDS), which allow traders to place bets on the creditworthiness of a company or a group of companies, have been around for decades in developed markets. Yet, such securities are little used in China. Instead, credit risk mitigation warrants (CRMW) are the most commonly used hedging tools. Despite being widely known as China’s CDS, the instrument is not exactly that. A CRMW offers insurance against default linked to a specific bond or loan obligation, while a CDS, which China introduced in 2016, can be linked to an issuer or its various debts.
4. Who’s using them?
Private developers including Longfor Group, Seazen, Midea Real Estate and Country Garden have been on the front line this year in selling domestic bonds protected by risk-hedging derivatives, indicating regulatory support. As of June 1, 54.8 billion yuan ($8.2 billion) of CRMW have been sold in the interbank market since 2018, Bloomberg-compiled data shows. That’s a tiny amount compared to China’s 138.2 trillion yuan onshore bond market, according to data from the People’s Bank of China.
5. Who takes the risk?
The seller. There are 34 issuers of CRMW, with China Zheshang Bank Co., China Bond Insurance Co. Ltd. and Bank of Communications Co. topping the list, according to data compiled by Bloomberg. Most are state-owned banks and brokerages except for China Bond Insurance, which is a state-backed, specialized firm. The dealers must be approved by their self-regulating organization, the National Association of Financial Market Institutional Investors, and there are 125 dealers. The fees charged by CRMW providers, which is almost like an insurance premium, range from 0.1% to 4.1%, according to data compiled by Bloomberg.
6. How effective are they?
Unknown. As of early June, there has been no default on any of the 346 onshore notes protected by CRMW to provide a test case, according to data compiled by Bloomberg. That’s mainly because issuers that are able to sell bonds with default insurance almost invariably carry safer credit ratings already, and thus are 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 for the deeply distressed builders. Hedging tools for the riskiest borrowers remains a rarity, leaving investors exposed.
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