Li Warns of Risks as Yields Drop Most Since Lehman: China Credit

Mar 31, 2014 1:05 am ET

March 31 (Bloomberg) -- China’s short-term bond yields are sliding at the fastest pace in five years as speculation builds that monetary policy will be loosened to combat what Premier Li Keqiang says are “difficulties and risks” for the economy.

The yield on the government’s two-year bonds tumbled 93 basis points this quarter to 3.41 percent, ChinaBond data show. That would be the biggest decline since a 214 basis point drop in the final three months of 2008, when global credit markets seized after Lehman Brothers Holdings Inc. collapsed. The average yield on local currency sovereign debt in emerging markets fell five basis points since Dec. 31 to 5.51 percent, according to data compiled by Bloomberg.

Premier Li’s warning, given at a meeting last week, that China can’t ignore the dangers of increasing downward pressure on the economy has spurred bets the government will roll out measures to stabilize growth as indicators such as manufacturing signal a slowdown. As part of the initial steps, the People’s Bank of China may cut lenders’ reserve requirement for the first time since May 2012, according to Credit Suisse Group AG and Nomura Holdings Inc.

“The fall in the short-term bond yield is driven by easing expectations and also an overall reduction of durations by investors on the back of ongoing risk aversion,” said Wee-Khoon Chong, Nomura’s Singapore-based head of rates strategy for Asia ex-Japan. “Yields tend to fall and bond curves tend to steepen in an easing environment.”

Reserve Ratio

The difference between two- and 10-year rates, a gauge of the so-called yield curve, widened 88 basis points since December to 110 basis points, ChinaBond data show. Comparable spreads are 53 in Brazil, 119 in Russia and three in India. China will lower the reserve-requirement ratio for major banks by 50 basis points to 19.5 percent in the second quarter, Nomura and Credit Suisse forecast. A cut of that size would free up about 500 billion yuan ($80 billion), Chong estimated.

Increased lending would help spur demand in the world’s second-largest economy, which will expand 7.4 percent this year, according to the median estimate of economists in a Bloomberg News survey. That would be the slowest growth since 1990, and below last year’s 7.7 percent as well as Premier Li’s 7.5 percent target.

The official Purchasing Managers’ Index for manufacturing will probably come in at 50.1 for March, the slowest since June, according to another Bloomberg survey before data due tomorrow. Consumer prices climbed 2 percent from a year earlier in February, the smallest increase in 13 months, while aggregate financing of 938.7 billion yuan was less than economists forecast.

Main Concerns

“Economic growth, inflation and credit expansion are the PBOC’s main concerns,” said Cici Wang, a Beijing-based fixed- income analyst at Citic Securities Co., the nation’s largest brokerage by assets. “Since the second half of last year, all three have slowed, so there are no reasons to tighten monetary policy.”

The PBOC has engineered a drop in the yuan by increasing supply of the currency, as is evident from a decline in money- market rates, BoCom International Holdings Co. Beijing-based analyst Li Miaoxian wrote in a March 24 note. The drop was orchestrated to discourage one-way appreciation bets, Li said, as the PBOC doubled the currency’s trading range to 2 percent on either side of a daily fixing. The yuan has lost 2.8 percent this quarter in what would be the biggest loss in two decades. It fell 0.21 percent today to 6.2255 per dollar as of 11:43 a.m. in Shanghai.

Rate Rebound

The seven-day repurchase rate, a gauge of liquidity in the financial system, averaged 3.21 percent in March, compared with the quarter’s 4.04 percent, according to a fixing compiled by the National Interbank Funding Center. The rate rose 59 basis points last week to 4.18 percent in a recovery that signals the PBOC is no longer pumping yuan into the market, BoCom’s Li said.

“The best days in terms of liquidity are behind us,” analysts led by Qu Qing at Shenyin Wanguo Securities Co. wrote in a March 27 note. The economy may bottom out in the second quarter, with inflation, estimated at 2.5 percent to 2.6 percent in March, starting to rebound, according to the report.

The government has policies in reserve to deal with any economic volatility this year, Premier Li said at an economic meeting in Liaoning province on March 26. The nation will use measures including various monetary policy tools, financial reforms and the development of a multi-tiered capital market to lower companies’ financing costs, Li said.

Cutting banks’ required reserve ratio will send the wrong signal to markets that monetary policy is starting to be loosened, which isn’t in line with the goal of controlling liquidity, according to a commentary today in China’s Financial News, a PBOC publication.

Risk Appetite

China had its first onshore bond default this month as Shanghai Chaori Solar Energy Science & Technology Co. failed to pay interest on debt. Defaults will accelerate this year, which is needed “to teach people a lesson,” said Vincent Chan, Credit Suisse’s Hong Kong-based head of China research.

The PBOC has singled out local government financing vehicles, industries with overcapacity and property developers as the three types of debt that face the highest default risks, a fourth-quarter monetary policy report showed. Local government debt rose to 17.9 trillion yuan as of June 2013 from 10.7 trillion yuan at the end of 2010, according to National Audit Office data.

Deposit Rates

PBOC Governor Zhou Xiaochuan said this month that deposit rates will be liberalized in one to two years, while the China Banking Regulatory Commission approved a trial of five privately-owned banks. Zhou reiterated interest rates will initially rise as controls are removed. The government pledged March 5 to introduce a deposit insurance system, after removing a floor on what banks can charge for loans last year.

“Many fund managers shunned longer maturities and favor shorter ones, because they see higher risks,” said Wang Ming, Shanghai-based marketing director at Shanghai Yaozhi Asset Management LLP, which oversees 2 billion yuan of fixed-income assets. “The long end of the curve is waiting for a trigger to fall. It could be worse-than-expected economic data released in April, or a reserve-requirement ratio cut.”

--With assistance from Helen Sun in Shanghai and Justina Lee in Taipei.