The Co-Movements of Credit Default Swap Spreads in China

ABSTRACT

In this paper, we study systemic risk in China using information from the credit default swap (CDS) data of Chinese firms. We find a large time variation in CDS spreads. More importantly, firms’ CDS spreads co-move with each other and the first three principal components (PCs) explain 94% of the time-series variation in CDS spreads. We further identify a set of economic risk factors that drive the co-movement of CDS spreads. Large external economic shocks shift a significant proportion of the variance explanation power from the factors related to China’s domestic economic condition to foreign trade and money supply. Our results reveal the sources and dynamics of systemic risk in China.

KEYWORDS:

• Systemic risk
• credit default swap
• China
• principal component analysis

JEL:

• G10
• G28

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. https://www.im.natixis.com/intl/markets/is-evergrande-a-systemic-risk-to-china.

2. We also conduct analyses using an extended sample of 25 Chinese entities (from 2013 to 2020) and obtain similar results.

3. To mitigate the counterparty risk, the U.S. Congress passed the Dodd-Frank Act to mandate central counterparty (CCP) clearing for eligible CDS contracts. As part of the Dodd-Frank Act, the International Swaps and Derivatives Association (ISDA) introduced several important rule changes to standardize the CDS market in April 2009, known as the CDS Big Bang. The CDS Big Bang improved the overall liquidity of the CDS market. Since our sample period begins from April 2009, the CDS spreads in our sample are not likely to have a significant portion of counterparty risk and liquidity risk.

4. We also try adding exogenous variables such as the China ETF50 volatility index and one-week repo rate in the VAR regressions and obtain similar results.

Additional information

Funding

The work was supported by the National Natural Science Foundation of China [72171107]; Southern University of Science and Technology [Y01246110]