China Money Week: US Tax Reform Won't Hurt Bonds In Short-Term

--If U.S. Growth/Inflation Rise, Higher U.S. Treasury Yields To Hit China Yields

--PBOC Not Expected To Raise Rates In December Due Tax Reform, Fed Rate Hike

     BEIJING (MNI) - The final passage of U.S. tax reform is unlikely to have a

significant negative impact on the Chinese bond market in the short-term,

because it will take time for the tax changes to have any significant impact on

U.S. growth and inflation, Chinese analysts and traders say.  

     But in the longer run, if the expected tax cuts stimulate U.S. growth and

inflation, they would boost U.S. Treasury yields and so put upward pressure on

Chinese bond yields, they added. 

     In any case, the People's Bank of China is not expected to raise its

interest rates in December in response to the passage of the U.S. reform or the

expected Federal Reserve interest rate hike, they told MNI.

     LITTLE REACTION TO SENATE PASSAGE OF TAX REFORM PLAN

     The U.S. Congress is expected to approve in coming days a tax reform

package, the centerpiece of which is a large cut in the U.S. corporate tax rate.

That could prompt large U.S. firms to repatriate to the U.S. profits now held

abroad, which could increase capital outflows from China. Moreover, stronger

U.S. corporate balance sheets expectations of stronger U.S. growth could prompt

an increase foreign investor demand for the U.S. dollar, which could weaken the

yuan and so put pressure on the PBOC's monetary policy.

     However, the Chinese bond market reacted calmly to the news last Friday

that the U.S. Senate had passed the tax reform bill, with the 10-year China

government bond yield rising only slightly from 3.8852% Friday to 3.8902% on

Monday, before falling back to 3.8752% on Tuesday.

     "[Senate passage of] tax reform caused bond yields to go up in the morning,

while in the afternoon the yields began to fall without any clear reason," a

Beijing-based bond trader at an asset management company told MNI Monday. "I

think it was due to improved market sentiment" as a result of recent better

liquidity conditions and the China Development Bank's maneuvers last week to

bring down bonds yields.

     TIME-LAG BEFORE TAX REFORM HAS IMPACT

     Other traders argued U.S. tax changes would not have a big impact on the

U.S. economy in the short-term, so the immediate impact on the Chinese bond

market would be limited.

     "Tax reform will certainly have an impact on the bond market, but the

impact in the short-term will be very limited," a Beijing-based interbank trader

at a commercial bank told MNI. "That's because the influence of tax reform will

be more long-term and still quite uncertain, and so we need to see what will

happen."

     Sun Binbin, an analyst at Tianfeng Securities, argued that there will be a

"significant" time lag between the implementation of U.S. tax reform and its

economic stimulating effects. It will take some time for the legislation to

boost the U.S. economy and push up inflation rate, which will ultimately result

in higher U.S. long-term bond yields and lead to pressures on China bonds

yields.

     Analysts generally dismissed worries that the U.S. corporate tax cut would

push companies to move some production from China back to the U.S., increasing

capital outflows and reducing U.S. foreign direct investment in China.  

     "The U.S. tax reform package will lower the [corporate] tax rate to 20%

from 35%, but that is not a big advantage against [the corporate tax rate] of

25% in China," Li Chao, analyst at Huatai Securities said in a report on Monday.

"Moreover, China has lowered the tax rate for high-tech companies and

foreign-owned corporates," making it more attractive for foreign-owned firm to

establish branches in China.

     "Besides, the tax rate is not the only factor determining where companies

want to produce. Labor costs, land resources, climate and other factors affect

the comparative advantages of different counties and affect companies'

decisions," Li argued. "The comparative advantages of China and the U.S. are

quite different so [U.S.] tax reform will not shake up the current situation."

     Moreover, self-reinforcing capital outflows caused by any yuan depreciation

speculation will not be quite as serious as it was earlier this year, some

analysts argued.

     "Improved China economic conditions will solidly support the yuan exchange

rate, and more companies have been borrowing dollar-denominated debt, which will

help to balance cross-border capital flows," analysts at Shenwan Hongyuan

Securities said. "The one-sided depreciation expectations for the yuan have been

broken and investors have become more rational about exchange rate fluctuations,

so the pressure on the yuan is controllable."

     NO NEED FOR PBOC TO REACT TO FED HIKE

     A stable yuan exchange rate gives domestic monetary policy for leeway,

alleviating pressures for the People's Bank of China to hike interest rate after

the expected Federal Reserve rate hike next week. 

     "I do not think the PBOC will follow the Fed hike rate this time given that

the pressures from capital outflows and yuan depreciation have waned to a large

extent," an interbank trader at a commercial bank in a coastal province told

MNI. "Fundamental conditions do not require the PBOC to hike its rates because

there are no signs of overheating in the economy. And sentiment in the bond

market is pretty fragile right now, so a rate hike would hurt sentiment and very

likely have a big negative influence on bond yields."

     Analysts at China International Capital Corp. pointed out that monetary

conditions have been relatively tight in China, with credit spreads and term

spreads at very low levels. This gives financial institutions no incentive to

leverage up, so there is no reason for the PBOC to raise its open market

interest rates, as it did in March.

     Traders said the effect of the Fed's rate hike has been already "priced

in", so the actual announcement won't have a big influence of the domestic bond

market.

     GOOD TIME TO BUY CHINA BONDS

     Market players continue to pay closer attention to domestic conditions --

especially economic fundamentals and the progress of new regulations -- than

foreign developments.

     "As there are multiple pieces of bad news still lingering in bond market,

including the question of the durability of economic conditions, regulation

policies and so on, the bond market is likely to fluctuate in the short-term and

the long-term trend has not been established," analysts at Guotai Junan

Securities said on Wednesday. "But if we assume that current yields are

technically a bottom in the short-term, there might be some trading

opportunities later. So we suggest that investors not buy if the yields remain

the same, but buy more if yields go up a lot."

     CICC analysts argued that current bond yields are very attractive for the

long-term, so long-term investors can begin to buy gradually. But it will be

some time before yields finally fall, so long-term investors do not have to

hurry.

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

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