The final HSBC/Markit Economics’ China PMI for September came out today with a reading that was above the flash estimate, but still at a level that signals contraction. Also evident was a worrying increase in factory inputs inflation, putting China’s central bank in an uncomfortable position in the face of a global slowdown.
Into the breach comes CDS referencing China! If you are appropriately sceptical, you’ll rightly question the quality of this particular, controversial metric. Before we get into the guts of it, let’s take stock of the situation.
This chart shows the closing levels. China CDS is currently being quoted at 196bps, a considerable intraday jump from the 177.80 you see above.
How big is it?
In September 2009, CDS referencing China were the 227th biggest single-name out there. A net notional of $1.6bn outstanding was spread across 2,189 contracts. In other words, it wasn’t that liquid at the start of the graph above.
But a year later China CDS had jumped to 26th place with a net notional of $4.2bn and 3,486 contracts. And finally, last week it was in 11th place with $7.9bn and 5,619 contracts.
(CDS referencing Greece have less than half of that net notional, by the way, so if you’re trying to avoid triggering them, remember to look down or you might miss them.)
How active is it?
To answer that question, we have to look at the actual trading activity — and that, as it turns out, has had some considerable spikes lately.
In case the quantum on the left y-axis is confusing in its magnitude, the thing to remember is that DTCC’s net notional figures are netted across maturities. Also terminations count towards activity. In other words, not all of the weekly activity in a given single-name will lead to an increase in net notional.
Who trades it?
From the above, it can be seen that China CDS is an active single-name contract which has a large number of positions outstanding. Furthermore, the spread seems to be responding in a natural way to the economic situation by deteriorating, i.e. by widening. But who is buying this stuff? Or selling for that matter?
For that, FT Alphaville goes back to one of the best sovereign CDS primers ever, Citigroup’s “You can’t blame the mirror for your ugly face.” Here’s their list of market participants:
Bank counterparty hedging / “valuation adjustment” (CVA) desks tend to be buyers of protection to hedge government exposure or manage regulatory limits. Banks run up quite large derivative MTM exposures to multiple sovereigns.
Correlation desks wanting to incorporate sovereign risk in structures such as first-to-default baskets and credit-linked notes are net sellers of protection.
Prop desks and credit funds tend to be both buyers and sellers, looking at relative value, basis and skew trades.
Hedge funds have been buyers and sellers and by definition have taken on all sorts of trades, but many have been looking at negative basis trades.
Real money accounts are both buyers and sellers, looking to go take advantage of the positive basis in CDS markets and looking at relative value ideas.
Emerging market funds have been getting increasingly involved in G20 sovereigns as the spread difference between the two markets has become blurred.
The note from Citi was written in March 2010. Since then, the number of participants using China CDS as a pure hedge against the economy has increased. If you’re a European or American company that has dependencies on Chinese businesses, how else are you going to hedge the macro risk? CDS also have a handy feature in that:
They can (theoretically) be traded in any maturity, currency, or used to construct broad market indices or structured products.
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In fact, the need to hedge against a slowdown has even impacted credit derivatives that are linked to China via trading relationships, as increases in activity on the Markit iTraxx Australia over the summer can attest.
In other words, while China CDS are just one signal, they may prove to be an informative one.
Related Links:
Put (CDS) trading activity where your mouth is – FT Alphaville
CDS Trade Information Warehouse - DTCC
HSBC/Markit China Manufacturing PMI - Markit