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[SHANGHAI] Support for China's economy from the central bank has been put at risk by a surge in municipal bond issuance that has driven up yields, undermining its efforts to cut borrowing costs.
Heavily indebted local governments seeking to refinance expensive debt have issued more than 600 billion yuan (S$129 billion) of municipal bonds in the past month - more than in all of 2014.
Traders are betting government bond yields will rise rather than fall in coming months on the back of more debt sales, producing a tug-of-war between a People's Bank of China (PBOC) determined to prop up flagging economic activity and a bond market awash with supply.
"The sudden fall in government bond futures really runs against the overall monetary easing trend," said a senior trader at a major Chinese bank. "It reflects market sentiment that investors are supplied with too much new debt of late, including local government bonds." Five-year September 2015 government bond futures suffered their worst trading day of the year on May 26.
Driving the huge new issuance of municipal bonds is an estimated 22.6 trillion yuan of high interest local government debt, which provinces are struggling to refinance more cheaply.
Nomura estimates the municipal bond market will grow 1,000 per cent to 12.1 trillion yuan by 2020 - larger than the size of the entire treasury market now.
With local government spending collapsing in the second quarter to just 1.2 per cent growth from a year earlier and investment growth at a 10-year low, the PBOC has little choice but to support heavy municipal bond issuance and keep bond yields in check.
Analysts suggest recent policy moves, including cheaper rates in its long-term pledged supplementary lending (PSL) facility, are designed to do just that. "Recent developments suggest that the PBOC's primary mandate, at least for now, is supporting fiscal expansion by safeguarding the issuance of local government bonds," PRC Macro Advisors said in a report.
However, the central bank has since February repeatedly struggled to stop medium-term interest rates from rebounding.
Since mid-May, 5-year treasury yields have risen nearly 30 basis points to 3.26 per cent, while 6-month forwards have opened up a 120-basis-point premium over the 5-year spot rate.
MARKETS VERSUS PBOC
The latest rebound in yields is part of a worrying pattern that has persisted since the beginning of the year.
After the PBOC's rate cut on Feb 28, bond yields initially spiked rather than eased, as the announced expansion of municipal debt market issuance undermined the rate cut's impact.
Yields fell only when the 1.5 trillion yuan National Social Security Fund said it would purchase a portion of the new debt on April 1.
Then after interest rates were cut on May 10 - the third cut in six months and bringing the one-year lending rate to 5.1 per cent - bond yields fell but bounced back a week later when the flood of new provincial bond issuance began on May 18.
Again, bond yields fell only once policymakers resorted to unconventional measures, namely cutting the rate on loans provided under the PBOC's PSL programme - a long-term liquidity facility for banks backed by, among other things, municipal debt.
But even that fall in yields has proved transient and yields are now close to their June 1 highs.
The PBOC may have to ease more aggressively, including cutting bank requirement reserves, to ensure base rates do not rise further.
Linan Liu, Deutsche Bank's Greater China rates strategist, said in a report the investment bank expects at least another 4.4 trillion yuan of municipal bond issuance during 2016-2017. "To prevent the long-term risk-free rate from rising excessively due to government bond supply, we expect the PBOC to increase long-term liquidity operations such as the PSL."