India's central bank on Wednesday night released long-awaited draft guidelines for banks and dealers to begin trading credit default swaps in the country – derivatives that allow banks to hedge against the risk of default.

The move will enable banks in India to step up lending to the corporate sector by allowing them to offload some of the risk to third-party investors.

"As a part of the gradual process of financial sector liberalisation in India, it is considered appropriate to introduce credit derivatives in a calibrated manner at this juncture," the Reserve Bank of India said in a release addressed to the country's commercial banks.

The draft guidelines, which will be subject to consultation with the banking sector before a final version is released, come at an important time for India's banking sector.

With the economy growing at more than 8 per cent annually, loan growth in India has been running at about 30 per cent a year.

The country's corporate sector is gearing up for what some bankers are describing as an historic increase in investment in infrastructure and manufacturing.

ICICI Bank, the country's largest private lender, has estimated Indian companies are planning to invest $500bn over the next three years – the equivalent of the country's entire existing investment stock.

However, if banks are to increase lending to serve this rise in capital expenditure, they will need to simultaneously have the ability to offload risk.

In other countries, credit default swaps have proven to be a valuable tool to enable banks to hedge their exposure to single borrowers and sectors, said Tarun Kataria, managing director, head of corporate, investment banking and markets, India, at HSBC.

"CDS are an important portfolio and credit exposure management tool for global banks and the ability to do the same in India would be very useful," said Mr Kataria.

The RBI said the move to allow the trading of CDS' followed an increase in the sophistication of the domestic banking sector.

"The risk management architecture of banks has strengthened and banks are on the way to becoming Basel II compliant, providing adequate comfort level for the introduction of such products," the RBI said in its annual policy statement for 2007-2008.

But it said that because of the complexities involved in the valuation, accounting and risk management aspects of credit derivatives and the "evolutionary skills" of eligible participants, it would limit the range of CDS allowed for now to instruments where the reference entity is a single entity. The contracts traded are also required to be denominated and settled in Indian rupees.