China to Allow Credit Default Swaps

China has given the green light to controversial credit default swap trading for the first time, signalling that Beijing is willing to let indebted companies fail to stop economic slowdown.

In a country where the government usually helps firms facing problems, the move will allow the market to absorb the shock of defaults, which will happen much more frequently.

China's central bank has approved "the mitigation of credit risks," the National Association of Financial Market Institutional Investors (NAFMII) said in a statement on Friday.

Credit default swaps are a kind of insurance underwritten by an investor which guarantee the repayment of bonds in case of default.

They came in for heavy criticism in the West after the 2008 financial crisis, accused of being a speculative tool that conceals the extent of risk. The swaps were instrumental for the dramatic fall of the US insurer AIG.

However NAFMII has insisted the credit default swaps "will perfect risk-sharing mechanisms".

Beijing has said it will let the most indebted companies  -- especially the so-called "zombie" firms that have long ceased to be profitable -- go bankrupt.

"CDS pricing can also reflect which companies the government may be more willing to bail out,” Iris Pang, senior economist of Greater China at the bank in Hong Kong, told Bloomberg.

China has seen bad loans climb to 1.4 trillion yuan ($210 billion) in the first half of the year, the highest in 11 years, according to Bloomberg.