So I wanted to write a few more technical issues on China’s CDS market as a follow up to my Bloomberg View piece. As usual start there and come here.
- I hate to sound so negative, I really do, but this is another incredibly poorly thought through idea that seeks dress up symbolism as some type of real reform. There are so many technical problems that simply have not been thought through.
- Though it is not the same type of instrument it is a very close parallel, credit or loan guarantee firms already exist to manage this focusing on SME. Though there is not good data on these firms and their pricing schemes, evidence seems to indicate that there is little price discrimination on credit quality. This implies that either existing firms do not or are not allowed to change the price based upon the risk of the borrower. Given the lack of price dispersion in the bank loan market based upon credit quality this seems to indicate that the pricing mechanism is simply not being used in the credit market.
- The reason that the lack of price movement in the credit risk market matters is why if it is not moving from the major banks in China in these other major financial institutions do we think that it would move significantly with the introduction of a CDS market? One of the primary purposes of the CDS market is to provide a clear, transparent regular price for the default risk of a specific firm. However, there is little evidence in any market that China would allow the market to accurately price the risk given the prevalence of intervention in asset price markets to set a price preferred by the government. If the market cannot set price for default risk, the government is better off leaving this market absent.
- There is also the lack of market reform that makes this even more of a concerning move. Assume ICBC has a 100m RMB loan to a coal company and Bank of China has a 100m RMB loan to a different coal company. They both want to hedge their default risk so they buy a CDS that covers their potential losses so ICBC buys a CDS from BoC and vice versa. Now both are worse off because there has been no net change to the total risk level but both think they are better off and potentially become even riskier after purchasing the CDS. Unless there are large outside investors selling to people wishing to hedge potential losses nothing has changed and people believe they have hedged their risk potentially allowing them to absorb more risk believing they are covered.
- There is also an important psychological point here that has been overlooked. When China is controlling the price it is normally through more opaque methods and markets. For instance, we do not know exactly when the PBOC intervenes in currency markets or how much. Furthermore, the risk is much more macro oriented or focused. However, in a CDS market it focuses the attention on a weak firm and has an important psychological impact. Even if the government intervenes, it will only be calling to attention to the state of a weak firm. This has the ability to concentrate attention much more on the weakness of a firm or industry that it might other wise be able to obscure.
It seems a lot more like a symbolic reform of sound and fury signifying nothing that has not been thought through.