Friday, 25 August 2006

Pegged CDS spreads

I was reading Chris Patten's musings on Hong Kong, East and West,--it's not bad, but his unquestioning faith in free markets is a little naive,--when it occurred to me to wonder what a market with pegged CDS spreads would be like. Indulge me with this thought experiment. Patten points out quite rightly that one of the problems with China is a banking system rotting from the inside thanks to inappropriate lending at the wrong spread. This classic failure of managed economies typically causes a huge problems when the banking system needs to be recapitalised. OK. So how could this be avoided? Pass on some of the risk. But no one will buy these loans at anything like par given the spreads they were made at. But we know how to deal with an uncooperative market - fix the price. It worked in FX for many years - that was called Bretton Woods. So what would an economy look like when the government or its cronies dictated the 'fair' value CDS spread of local corporates? It might not be pretty, but it is an interesting question.

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