China is in credit market crosshairs

Which country saw the cost of insuring its sovereign debt against default rise more in the third quarter, Spain - the country that puts the S in PIIGS - or rising economic titan China?

The answer is China, as concern grows in credit markets about the outlook for the country’s economy.

China’s five-year sovereign credit default swap was among the 10 worst performing sovereign CDS in the world in the third quarter. The cost of insuring a Chinese five-year bond against default rose 136 per cent, according to a third-quarter roundup by debt market research firm Markit.

Spain, meantime, was among the 10 best performers, with the cost of insuring a five-year government of Spain bond rising by 49 per cent. To be sure, the absolute cost of insuring a Spanish five-year is still much higher than a Chinese bond of matching duration, but the gap is shrinking.

The cost of insuring a Chinese bond is now much greater than for core European countries such as Germany, Denmark and the Netherlands, as well as Britain. CDS markets in recent years have become leading indicators of trouble spots in the global economy, as traders have flocked to the derivatives as a way to bet on the health of countries and companies.

The divergence also says something about the global economy and what credit investors see in it. For credit market investors, European countries aside from Greece that were the first to run into trouble are now becoming less of a concern, while the Chinese economy that the world has viewed as a saviour is increasingly viewed as a source of concern.

“With all eyes on Europe, western investors were sometimes guilty of forgetting about China this year,” Markit credit analyst Gavan Nolan wrote. “China’s CDS spreads spiralled upwards from a respectable 75 basis points to 200 basis points as investors feared that the world’s most resilient growth engine was slowing.”

(That means an investor buying CDS protection against default on $10-million of bonds now pays $200,000 a year.) In fact, while China was viewed as a trouble spot, Ireland and Iceland top the list of best performing sovereign CDS in the quarter. Ireland, which is pushing through austerity and dropping labour costs, was the only country tracked by Markit that saw its sovereign CDS spread shrink in the quarter as investors were impressed by the country’s return to competitiveness, Markit said. Iceland got results by devaluing its currency.

When it comes to China, investors are buying more and more default protection at higher and higher prices.

Their concerns revolve around slowing exports and the country’s efforts to cool its domestic economy, as well as the possibility that a property bubble bursts and causes a “hard landing,” Mr. Nolan wrote.

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