China Bond Rally May Stir Up Trouble for Beijing Regulators

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07/12/2017 | 10:42 am


By Shen Hong



SHANGHAI--A Chinese bond rally--bucking the global selloff in government debt--is narrowing the yield gap with U.S. bonds, a potential complication for Beijing.



Prices in the world's third-largest bond market have recovered in recent weeks as Chinese regulators back off efforts to discourage risky loans and cool debt-fueled speculation. That has sent yields falling--to 3.54% on the benchmark 10-year government bond, from a two-year high of 3.69% in early May.



Meantime, yields on U.S. Treasurys and German bunds have risen as leading central banks signal that their loose-money policies--which have propped up the world economy since the global financial crisis--are nearing an end.



The result: The yield gap, or spread, between the benchmark 10-year Chinese bond and its U.S. counterpart has shrunk to 1.19 percentage points, a 20% narrowing since early June, when it was at its widest in nearly two years.



A smaller edge for Chinese assets could make U.S. assets, including bonds, more attractive to Chinese investors, tempting them to send their money out of the country--a flow Beijing has managed to slow in recent months by tightening capital controls.



In turn, that could deepen Chinese authorities' policy "trilemma," economists' term for the impossibility of keeping independent control over currency, interest rates and capital account.



"If U.S. interest rates rise further and the spread narrows more, it will certainly put more pressure on China's currency and encourage more money to head abroad," said Zang Min, senior fixed-income analyst at Hongxin Securities, a Shenzhen-based brokerage. And that, he added, could force the People's Bank of China to raise interest rates.



For now, investors in China are enjoying the easing of Beijing's crackdown on financial system risks. After earlier this year setting off market jitters by acting to stifle the buying of domestic bonds with borrowed money, in late May authorities shifted to a more conciliatory approach, and in mid-June the PBOC made its largest weekly injection of cash into the financial system in five months.



"These moves aimed at stabilizing the market have rekindled enthusiasm among some bond bulls," said Mr. Zang, adding that demand for bonds had almost dried up at one point. In the first half of 2017, Chinese companies raised a total of 1.99 trillion yuan ($292.53 billion) via bond sales, less than half the year-earlier 4.15 trillion yuan.



The newfound stability has come with a fresh concern: As the bond market recovers, so has the use of tools for adding leverage, notably a type of short-term loan known as a negotiable certificate of deposit, or NCD, that banks have being increasingly using to raise funds. Issuance surged to a near-record 2.01 trillion yuan last month.



Chinese banks, especially those with smaller deposit bases, have made heavy use of this relatively new instrument to roll over old debt and finance bond purchases, especially of higher-yielding corporate bonds.



As appetite for such riskier assets returns, the average yield on AA-rated five-year Chinese corporate bonds has fallen faster than the yield on safer AAA-rated bonds. Since mid-June the difference has narrowed to 0.52 percentage point from 0.87 percentage point, which was the widest in nearly a year.



"Based on indicators like NCD issuance, one can argue that the level of financial leverage has risen back again," said Qu Qing, chief fixed-income analyst at Hua Chuang Securities.



Write to Shen Hong at hong.shen@wsj.com





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