China just made a key preparation for disaster in its economy

Photo: Laurent Fievet / AFP / GettyImages

China has given its bond traders the go-ahead to begin trading credit default swaps (CDS), an indication that the government is preparing for more big corporate bankruptcies, Bloomberg reports.

Credit default swaps allow investors to insure themselves against the default of a given security.

Earlier this month the government allowed the first major state-owned organisation,
Guangxi Nonferrous Metals Group, to make preparations for bankruptcy.

It was a special moment. Never before had the country allowed a big state-run industrial company to go bust. Past bankruptcies involved only bank or corporate debt — this one involves 108 creditors.

That news, combined with the trading of credit default swaps, has analysts believing that many so-called “zombies” — China’s unproductive massive industrial companies who need debt to survive — may soon be put out of their misery.

“CDS will help investors mitigate the risk and alleviate market sentiment if investors face more defaults or suffer more losses after defaults,” Ivan Chung, head of Greater China credit research at Moody’s Investors Service told Bloomberg.

In other words, now investors can now bet on whether or not a zombie is about to bankrupt, giving themselves a little extra protection if a company fails, and the government opening up the CDS market suggests more willingness to let zombies die.

China has had the zombies in its crosshairs for some time now. In 2015 the government said that supply-side reform would become central to its economic policy. This is because China is trying to take its economy through the delicate transition from one based on industry and its manufacturing sectors, to one based on domestic consumption and services like banking and retail.

That means indebted companies in flailing industries like coal and steel must be restructured and their overcapacity dealt with. Unleashing a CDS market means that investors can hedge this transition and better navigate a world of rapidly deteriorating corporate credit quality.

We might be about to see some real winners and losers here people.

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