MNI China Money Week: Economic Fundamentals Key For Bond Mkt

     BEIJING (MNI) - Economic fundamentals have come into greater focus for

long-term bond traders and investors this week, with the recent spotlight on

liquidity conditions dimming ... for now.

     Liquidity conditions remained tight in the past week. On Tuesday, the PBOC

effectively drained a net CNY28 billion from the interbank market amid the

ongoing flow of tax payments, causing the CFETS-ICAP money market sentiment

index to close at 65 for the day, suggesting a tight liquidity level. Traders

said some financial institutions had defaulted on repos that day.

     "Today's liquidity condition was quite tight," a Beijing-based interbank

trader at a commercial bank said on Tuesday. "If you said in the QQ chatting

group that you have overnight money to lend out, your computer would shut down

immediately because there would be so many traders asking you the price at the

same time," he said. QQ is an instant messaging service widely used in China.

     On Wednesday, despite a net injection of CNY180 billion by the PBOC,

liquidity remained sticky, and the CFETS-ICAP index rose slightly to 66 at the

closing.

     "The tightness of liquidity conditions has been beyond market

expectations," the Beijing trader said. "Tax payments are just the surface

rationale," he said. "The root reason is the PBOC does not want liquidity

conditions to loosen too much."

     However, two consecutive trading days with tight liquidity did not help

lift the yields on 10-year government treasuries. The yield on the most actively

traded 10-year government treasuries, which mature Aug. 3, 2027, decreased from

3.5900% on Monday to 3.5750% on Wednesday, suggesting that liquidity is not the

main factor affecting long-term bonds yields.

     "The bond market's sensitivity to liquidity conditions has decreased," Xu

Hanfei and Wang Wanting, analysts at China Merchant Securities, said in a note

on Wednesday, adding that the liquidity tightness as measured by the increasing

spread between seven-day fixed repos and seven-day deposit repos -- which

widened to 113 basis points on Thursday from 19 basis points on July 14 -- had

caused much lower increases in long-term bond yields recently than in the past.

     "The relative insensitivity of long-term bond yields to liquidity

conditions probably suggests that the bond market leverage level has been

stable," Xu and Wang said. "The key factor affecting the bond market has shifted

from liquidity conditions to fundamental economic factors."

     Data published by the National Bureau of Statistics on Monday came in

weaker than expected. Industrial output grew 6.4% y/y in July, well below the

7.6% growth in June and the 7.0% expected in an MNI survey. Retail sales

increased 10.4%, down from the 11% increase in June and also below the 10.7% MNI

survey expectation. Property investment increased 7.9% during the January-July

period compared with the same period last year, down from 8.5% growth in the

first six months of the year. 

     Bond yields dropped after the data were released, with the yield on 10-year

government treasuries going from 3.6454% in the morning to 3.5900% at the close

Monday.

     However, stronger-than-expected credit and money data published Tuesday

puzzled investors, causing them to reconsider whether economic fundamentals were

in danger of weakening. Although M2 growth came in at a record low 9.2% rate for

the month, total social financing and new loans both exceeded expectations,

growing CNY1.22 trillion and CNY825.5 billion in July, respectively, though they

were both lower than the gains of CNY1.78 trillion and CNY1.54 trillion posted

in June. 

     Analysts have starkly different views on the outlook for China's economy,

with some, in line with the overwhelming market view, insisting that economic

growth is slowing. 

     "The fundamental supply-demand contradictions still exist: the high-speed

growth of manufacturing, the real-estate sector and infrastructure investment is

not likely to continue over the long run," Ming Ming, an analyst at CITIC

Securities, said on Monday. "So the evidence that the economic fundamentals have

improved has begun to weaken and the downward pressure on economic fundamentals

continues."

     Other analysts disagree.

     "We should not be too pessimistic about fundamental economic conditions, as

the July data were affected by adverse weather conditions," Hua Chuang

Securities said in a Monday report. "As temporary factors -- including high

temperatures, flooding and cuts in excess capacity -- fade away, the economic

data are likely to rebound. Even if the economic data continue to fall, if they

remain within the government's tolerance zone monetary policy won't be relaxed"

to benefit the bond market.

     Tang Yue, an analyst at Industrial Securities, said the July credit and

money data suggest the  financing demands of the real economy "remain steady"

and so economic fundamentals won't show signs of a weakening, at least in the

third quarter.

     Although economic fundamentals are likely to be the key factor affecting

bond market in the near future, some traders said the market should not forget

the lessons taught by regulators earlier this year and will likely remain

cautious about the "gray rhino" -- the big risk -- for the bond market: stronger

regulation.

     "I read an article today written by Wen Xinxiang, the Secretary General of

the People's Bank of China monetary policy committee, saying that the PBOC needs

to avoid providing excess liquidity just to benefit a few institutions or

product lines," the Beijing-based trader said. "That means the PBOC's risk

tolerance level has increased."

     "Especially considering there are relatively few articles from the PBOC or

other official media to pacify the market, I'm wondering if this is a sign that

stronger regulation is about to come back," the trader warned.

     The PBOC injected a net CNY110 billion in liquidity via reverse repos this

week, along with a net CNY112 via its Medium-term Lending Facility, resulting in

a total injection of CNY222 billion. There was also speculation that the PBOC

used its Standing Lending Facility on Thursday afternoon to alleviate the tight

liquidity in the interbank market, although there was no official statement

about this.

     The yuan was last traded at 6.6765 on Friday, weaker than the 6.6668 at

closing last Friday.

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

--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com

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

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