A tough sell: insurance against a China financial crisis

SINGAPORE, April 21 (Reuters) – Selling insurance against a

financial crisis should not be difficult, five years after the

last one nearly wrecked the global economy.

But when it comes to China, the world’s second-largest

economy, the probability of a full-blown crisis is apparently so

remote that hardly anyone will buy an insurance policy against

it, no matter how cheap.

Financial wizards have been trying to sell peace of mind to

investors in China for years, but fewer and fewer of those

investors are interested, despite some worrying headlines.

In the past few months alone, China has seen its first

domestic bond default, a small bank run, its weakest export

performance since the global financial crisis, a marked slowdown

in its property market and a rise in labour unrest.

Steve Diggle, a Singapore-based hedge fund manager who

crafts strategies to protect investors against financial

catastrophes, says investors have faith that the Chinese

government, armed with almost $4 trillion in foreign exchange

reserves, will simply not allow things to get out of hand.

He had to close down a fund that used to bet on doomsday

outcomes in Asia last year.

“There’s a sense you are playing poker against a guy who

makes his own chips,” Diggle said.

Before the 2008-09 global financial crisis, he had run a

successful fund, Artradis, which thrived on volatility in

financial markets. Now, he says, hedging against a catastrophe

seems to be passe – and not just for China.

Governments and central banks around the world have shown

themselves willing to deploy vast sums of money – China alone

launched a 4 trillion yuan ($643 billion) stimulus package in

late 2008 – to avert a financial meltdown.

“You are no longer in an environment where market forces

will play themselves out because you have an extraordinarily

powerful and motivated intervention in the market process from

someone, such as a central bank or government, who has a strong

ability to influence those processes,” said Diggle.

BETTING ON A BLACK SWAN

There are still some hedge funds that take out insurance

against extreme, improbable events – such as the notion that

China’s economic miracle will end in tears.

Andrew Wong, co-chief investment officer of Fortress Convex

Strategies Group, runs a fund that aims to make money from these

so-called “black swan” events.

“A pattern we’ve seen through long cycles is that in the

period leading up to a systemic crisis, people buy hedges, lose

money and unwind those hedges. Because it hasn’t been efficient

and has lost money, by the time the real thing happens they may

end up being completely unhedged,” said Wong.

“It’s very hard to time the market precisely, so in general

you need to have the insurance before the house is on fire.”

For cautious or contrarian investors, taking out insurance

on such apparently unlikely events as a China crisis has to be

cheap. It is futile to spend large sums of capital on so-called

tail-risk bets, waiting for such long odds to pay off.

Hedges can be expensive, though one relatively cheap method

is to buy put options on the yuan or on Chinese stocks at

strike prices well below current market levels.

Typically, though, the cheapest hedging strategies can also

be the most complex. One such strategy involves variance swaps,

a financial instrument that tends to pay the investor when

volatility of an underlying bond or stock spikes.

In hedging against the risk of a major outbreak of defaults,

a straight-forward approach such as buying credit default swaps

(CDS) is not the most cost-effective. Instead, funds will offset

the cost of buying CDS insurance against a distressed company by

also selling CDS protection against a more creditworthy one.

“If they want to hedge, it is relatively cheap,” said Camiel

Houwen, head of equity derivatives trading at ING Asia. “But not

too many people are setting up the trade.”

In China’s case, some fund managers think investors may be

overestimating the hold Chinese authorities have on markets.

“A China hard landing is not our base-case scenario, but if

it were to happen, it is one of these events that would have

significant implications for a wide number of assets,” said

Viktor Hjort, head of Asian fixed-income strategy at Morgan

Stanley.

“So it is a low-probability, high-impact type of scenario,

and against those it always makes sense to consider hedges.”

($1 = 6.2190 Chinese yuan)

(Additional reporting by Nishant Kumar in Hong Kong; Editing by

Mark Bendeich)

A tough sell: insurance against a China financial crisis