MNI China Money Week: Regulatory Concerns Weigh on Bond Market

--Possible Stricter Rules Over NCDs Seen As Big Risk

--Bond Yield Inversion Points to Slack Long-Term Demand

     BEIJING (MNI) - The Chinese bond market is likely to remain weak for some

time to come, given expectations that the government will further strengthen

regulation and amid relatively weak demand from long-term bond investors like

banks.

     "Last year I bought as much as I could without hesitation when the 10-year

China government bond yields reached 3.0%," a Beijing-based bond trader at an

insurance company said, expressing concern for the bond market outlook. "But I'm

very afraid to buy now even when the yield is near 4.0%."

     Beyond market structural concerns and overall weak market sentiment,

investors' worries over potential regulatory changes is the key factor behind

their cautious outlook. 

     In a survey conducted by Haitong Securities last week, 76% of bond

investors agreed that financial regulation is the main risk in the bond market,

much higher than other worries, including U.S. Federal Reserve interest rate

hikes, domestic inflation, tighter monetary policy and continued strong economic

conditions. Some 94% of the survey respondents believe financial regulation will

not be relaxed, with 37% of those predicting financial regulation will become

stricter.

     "Stricter financial regulation is likely to be the trend, so investors have

no way to alleviate their concerns," Jiang Chao, an analyst at Haitong

Securities, said on Tuesday. "The 19th National Congress report said the

economic growth model will shift from high speed to high quality ... implying

there won't be a flood of credit in the future."

     Stronger regulation of the interbank market, especially concerning the

issuance and holding of negotiable certificates of deposit (NCDs), would have a

significant negative impact on the bond market.

     "For banks, their interbank business is certainly a target for regulators,"

Jiang said. "If regulators tighten up their regulations of interbank NCDs, banks

will be forced to contract their liabilities and consequently force them to

contract their asset side, and government bonds are the easiest assets to sell."

     "So stricter regulation will certainly cause CGB yields to go higher,"

Jiang continued.

     This week, the yield of the most actively traded 10-year CGB, maturing on

Aug. 3 2027, dropped from 3.9050% at last Friday's close to 3.8650% on Thursday

before rising to 3.8800% on Friday, thanks to relatively good liquidity

conditions and a technical rebound after last week's sharp yield rise.

     Banks and other financial institutions seeking long-term holdings may jump

into the market and slow the expected drop in yields, but not on a large-enough

scale to reverse the market trend.

     "You can see the results of today's bidding for CGBs; the demand was quite

strong," a Beijing-based bond trader with one of China's "Big Four" state-owned

banks told MNI on Wednesday. "The price level seems quite attractive right now,

at least for us."

     The Ministry of Finance sold one-year and 10-year CGBs on Wednesday at

yields of 3.54% and 3.82%, respectively, both lower than the secondary market

yields of 3.5791% and 3.8630% on the same day. 

     However, attractive prices do not guarantee that banks and other long-term

investors will buy in large quantities. The spread between five-year and 10-year

CGBs widened slightly from 112 basis points last Friday to 119 basis points on

Wednesday and then inverted on Thursday, indicating there has been insufficient

demand from long-term investors to steepen the curve to where it would normally

be. 

     "Long-term investors will not just come in to buy [CGBs] or set an

attractive price level and buy as much as they can when the price falls below

that level," the Beijing-based bond trader said. "They will continue to watch

fundamental economic conditions and make their decisions" on when to buy. 

     In addition, banks may not be able to buy bonds in large amounts, analysts

argued.

     "As the end of the year approaches, banks often issue bonds to prop up

their Tier 2 capital to meet regulators' demands for the capital adequacy ratio.

And banks often hold each other's bonds, and that uses up their bond investment

quotas," China International Capital Corporation (CICC) said in a report last

weekend. "Also, the bond price movements will affect their profit-loss books and

capital adequacy ratios, leading to weaker demand for bonds, especially those

with long durations."

     The expected large amount of new bond supply in the fourth quarter will

only add further pressure on the market.

     "The net issuance of government bonds, local government bonds and policy

bank bonds is not [usually] small in the fourth quarter. Meanwhile, as [banks

reaching their] loan quotas restricts loans, companies might turn to issuing

bonds to get financing," CICC said. "So investors need to look at the potential

risks that higher primary market yields will lead to higher secondary market

yields."

     Looming additional bond supply isn't likely to motivate purchases by

short-term investors, who were burned by the last wave of rising long-term CGB

and policy bank bond yields and so are unlikely to bet on falling yields any

time soon, even though most analysts agree current long-term CGB yields are very

attractive for investors who can hold them for a long time.

     However, two scenarios might present short-term trading opportunities in

the Chinese bond market worth bond investors' attention.

     "First, if corporate bond yields begin to rise sharply, causing corporate

financing costs to rise, and so force net issuance of corporate bonds to fall

significantly, the PBOC might intervene to calm the bond market," Qin Han and

Xiao Chengzhe, analysts at Guotai Junan Securities, argued on Tuesday, referring

to the People's Bank of China.

     "Second, if the PBOC follows the Fed and raises its interest rates in the

next two months, bond market yields might rise a lot. This could be seen as the

last bad news for the bond market, so investors could bet on a rebound of bond

prices following the rate hikes," Qin and Xiao said.

     The PBOC injected a net CNY87 billion via open-market operations and

Medium-term Lending Facility (MLF) loans this week.

     The benchmark seven-day deposit repo (drepo) averaged 2.8625% this week, up

from 2.8672% last week.

     The yuan last traded at 6.6219 against the U.S. dollar on Friday,

strengthening from 6.6528 last Friday.

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

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

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

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