MNI China Money Week: Improved Liquidity Fuels Bond Rally

     BEIJING (MNI) - Improved liquidity conditions in the China money markets

have pushed bond yields lower in the last week, as some investors become more

optimistic about the outlook of liquidity. However, longer-term liquidity

concerns remain.

     The yield on the 10-year China Government Bond (CGB) and China Development

Bank bonds fell 5 and 8 basis points respectively, from 3.8702% and 4.8946% last

Friday to 3.8201% and 4.8101% on Thursday, back at yields last seen in December.

     Increased optimism over liquidity conditions remain the key driver for

lower bond yields. This pick-up in sentiment was helped Monday when the PBOC

injected a net of CNY150 billion into the banking system via its open market

operations despite ample liquidity in the system, contradicting expectations

that the People's Bank of China will actively drain liquidity from the banking

system after the spring holidays.

     More optimistic investors expect a change of monetary policy stance, with

last year's tight liquidity position moving to a more neutral stance this. The

optimism is triggered in part by the change of wording in the PBOC's fourth

quarter monetary policy report, with the central bank saying it looks to keep

liquidity conditions "reasonable and stable" from "generally stable" in the

third quarter report.

     --TIGHTER REGULATION

     With tight regulation set to continue in 2018 -- the widely-anticipated

asset management industry regulations are likely to published soon -- and with

the PBOC likely to hike its open market operations rate this year following rate

hikes by the Federal Reserve, liquidity will likely remain slightly relaxed to

help avoid systemic financial risks. The ample liquidity will help underpin the

domestic bond market.

     With the Two Sessions of National People's Congress and Chinese People's

Political Consultative Conference to be held in the early March, liquidity will

likely to remain relaxed as to keep the stability of the financial system in the

short run, providing a healthy environment for bond investors.

     However, longer-term liquidity remains questionable.

     There are concerns that if liquidity remains relatively stable it will

likely encourage financial institutions to again boost leverage, against the

PBOC's wishes. It will provide a carry margin for investors to borrow short-term

money and hold longer-term assets. Even if liquidity tightens occasionally, the

average cost will likely remain lower than the returns, making leveraging an

attractive strategy for financial institutions.

     Despite the recent recovery for bonds, it is too soon to call a market

renaissance. More local government bonds and policy bank bonds will be issued

after the Two Sessions, putting upward pressures on bond yields. New

regulations, likely effective after two Sessions, will cause uncertainties in

the market.

     Additionally, banks, the most important buyers of bonds, are lacking

long-term liabilities. The primary market rates of six-month negotiable

certificates of deposit (NCD) issued by city commercial banks rose to 5.10% on

Wednesday, the highest since the end of January, shows banks' appetites for

longer-term liabilities. The lack of stable long-term liabilities will restrict

banks' capabilities to invest in bonds.

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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