MNI China Money Week: Outlook Grim for NCDs as Bond Rout Bites

--Deleveraging Campaign Hitting Banks' Balance Sheets

--Competition For Funding Expected To Heat Up

     BEIJING (MNI) - Chinese banks that need to drink from the interbank market

to quench their thirst for funds are suffering as tighter regulation and the

continuing campaign to force financial institutions to deleverage reduces the

volume of liquid in the trough.

     Yields on negotiable certificates of deposit (NCD), an important source of

wholesale funding for small and medium-sized lenders without the huge deposit

bases of the big state-owned banks, have risen dramatically since October.

Primary market rates on three-month NCDs issued by joint-stock banks rose to

4.9100% on Friday, the highest since early June, up from 4.2999% on Oct. 9 and

4.5700% on Oct. 30, and heading for the biggest monthly jump since May.

     Primary market rates on three-month NCDs issued by city commercial banks

and rural commercial banks are even higher, standing at 5.0729% and 5.1060%,

respectively, on Friday. Rates have risen so much that since October it's been

costing banks more to borrow three-month money through selling NCDs than to take

unsecured loans from other banks based on the three-month Shanghai Interbank

Borrowing Rate (SHIBOR). 

     The jump in NCD rates comes at a bad time for banks, as they face massive

refinancing of maturing NCDs over the next two months just as demand is waning

as a result of the PBOC's financial deleveraging campaign and tighter

regulation. 

     A total of CNY2.1 trillion yuan of NCDs are set to mature in December, the

second-highest monthly total since the instruments were introduced by the PBOC

in December 2013, according to China Merchants Securities estimates. That comes

on top of the CNY1.8 trillion maturing in November.

     Although seasonal factors, including the need for banks to dress up balance

sheets to meet the requirements of the PBOC's Macro Prudential Assessment (MPA),

are partly responsible for the rise in NCD yields, the upward trend started much

earlier this year.  

     "This wave of rising NCD yields started in early October after the

[weeklong] National Holiday, while in the past few years, NCD yields only

started to rise from November," Qi Sheng and Long Shuo, analysts at Zhongtai

Securities, said.

     The primary market yields of three-month NCDs issued by joint-stock banks

has remained generally steady last October, rising from 2.8200% on Oct. 7 to

2.9100% on Oct. 27 -- the last trading day in October. 

     But the jump in primary market rates hasn't been triggered by banks

expanding their NCD liabilities, as net new issuance has been muted. 

     "Banks have been making efforts to meet the requirements of regulators in

the deleveraging campaign," an executive in the financial markets department at

an east-coast city commercial bank told MNI. 

     The campaign has targeted interbank assets and what the PBOC has called

"idle funds" sloshing around the system that have been used to leverage up

rather than lend to the real economy. "There are hardly any new interbank assets

like NCDs and interbank borrowings, and banks are just rolling over their

maturing NCDS to keep their balance sheets stable." 

     The net issuance of NCDs was negative in September and October, contracting

by CNY124.7 billion and CNY262.4 billion, respectively, although it has been

positive so far in November at CNY154.7 billion.

     The executive said he sees little chance of yields coming down in the short

term. 

     "It is more likely for NCD yields to go up than down for a while," he said.

"Supply of NCDs are still high as banks have such a high demand for wholesale

funds, and the competition for funding will get fiercer as the PBOC isn't going

to relax its monetary policy stance and big banks will be hesitant to lend out

money as year-end approaches."

     Banks dependent on NCDs for funding are being buffeted by a perfect storm

of tighter liquidity, the PBOC's strategy to increase money-market interest

rates to force deleveraging, slower growth in bank deposits, incentives for

lenders to direct credit to the "real economy" to qualify for a cut in their

reserve requirement ratios in January, and regulations that are curbing demand

for NCDs from banks, non-bank financial institutions and big money-market funds

such as Yuebao, the world's biggest fund, which is run by internet giant

Alibaba's affiliate Ant Financial. 

     Although the interbank market is now pretty much resigned to tighter

liquidity, especially after the PBOC's message in last week's quarterly monetary

policy report that dashed hopes for any loosening, stress is building. The

central bank was forced to pump CNY810 billion of liquidity into the market last

week through open-market operations, the most since January, as the sell-off in

Chinese government bonds (CGBs) deepened and repo rates surged. The central bank

returned to a more parsimonious stance this week, but still added CNY150

billion. 

     The cost of other types of funding is also rising. The Ministry of

Finance's latest auction of three-month deposits on Nov. 17 saw a yield of 4.6%,

up from 4.42% in October and the highest since early 2015. 

     Low excess reserves held by banks at the PBOC, a reflection of tight

liquidity conditions, are contributing to the shortage of funds. The central

bank said in its latest monetary policy report that the ratio was just 1.3% at

the end of the third quarter. 

     The PBOC's efforts to force banks to lend more money to the "real economy"

rather than investing in financial products is also having a negative impact on

interbank liquidity and demand for NCDs. The central bank announced on Sept. 30

that it will cut the reserve requirement ratio (RRR) for banks starting on Jan.

1, based on how much they loaned in 2017 to small and micro enterprises and

other borrowers that fall under the government's "inclusive finance" label. As a

result, lenders have been redirecting some of their funds to meet those

requirements and ensure they get the maximum RRR reduction on offer, which could

be as high as 1.5%. 

     "A lot of banks have been actively issuing loans to meet the PBOC's

criteria," a trader at a rural commercial bank on the east coast told MNI. "That

has left less liquidity in the system for NCD purchases and reduced demand for

NCDs among investors."

     Yields are also rising because of the relatively slow growth in bank

liabilities that has manifested itself in a significant drop in the pace of M2

expansion this year. M2 rose by 8.8% in October year on year, the weakest

increase on record.

     "I think the most important reason for the increase in NCD rates is the low

M2 growth," the executive at the city commercial bank said. "If overall deposit

growth has slowed so much, banks are having to compete really hard to get

funding, thus driving interest rates higher."

     The pressure on the liabilities side of banks' balance sheets is still high

as they need to meet regulatory requirements while at the same time avoiding the

need to dump assets.

     Banks must roll over their maturing NCDs because if they don't they will

have to sell assets, Qin Han and Gao Guohua, analysts at Guotai Junan

Securities, said in a report on Wednesday. According to their calculations,

outstanding NCDs issued by big banks, city commercial bank and rural commercial

banks amounted, respectively, to CNY179.6 billion, CNY3.91 trillion and CNY879.8

billion at the end of October, all record highs. Only joint-stock banks saw a

decline, although they still had CNY3.17 trillion outstanding. 

     "A common strategy for financial institutions now is to issue high-cost

debt so that their balance sheets do not contract, and then gradually replace

their low-yield assets with higher-yield assets" to minimize the impact on their

margins, they said. 

     The trader at the rural commercial bank said he expects NCD yields to keep

rising until mid-December but they may then soften as a significant amount of

fiscal spending is expected to kick in, which will add liquidity to the banking

system through the interbank market. 

     "The targeted required reserve ratio cut will also benefit liquidity

starting in January," the trader said.

     Higher NCD yields are adding pressure onto an already distressed bond

market.

     The average yield on 10-year Chinese government bonds continued its upward

path this week, rising by another 4.5 basis points as of Thursday to 3.9851%,

although it did break through the key psychological level of 4% several times

during the week.

     "The key factor pushing this wave of rising bond yields is the increasing

cost of banks' funding, which is squeezing their demand for bonds," China

Merchants Bank said in a report on Wednesday. "The negative impact of the 'tight

and balanced' monetary policy and the new regulations [announced last week] on

asset management products can be seen in the rising cost of funds." 

     CITIC Securities sees little prospect of yields coming down significantly,

forecasting that the 10-year CGB will be trading in a range of 3.8% to 4% for

some time. "Against the background of a deepened financial deleveraging campaign

and the PBOC's repeated statements that hinted the monetary policy stance will

not likely be moved by low M2 growth, pressure on banks' funding costs,

including NCDs, will continue," Ming Ming, an analyst at China CITIC Securities,

wrote in a report on Tuesday. 

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

--MNI Beijing Bureau; +44 203-586-2244; email: nerys.avery@marketnews.com

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

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