China bond selloff fears grow as liquidity starts to tighten

Hong Kong

CHINA'S sovereign bonds have defied expectations for a selloff all year but their day of reckoning may be getting closer.

The amount of cash in the banking system has been shrinking, while local government debt sales are set to double this week, hoovering up more funds. As a result, the overnight interbank interest rate rose to the highest level since February on Monday.

"Investors should be more cautious on the Chinese bond market in June," said Yin Ruizhe, a fixed-income analyst at China Merchants Securities in Shenzhen. "Local government bond issuance will make the market more sensitive to capital needs, especially as liquidity in the banking system has already tightened."

Benchmark 10-year bonds are yet to factor in much concern, though yields are starting to creep higher. The rate has climbed to 3.12 per cent from as low as 3.07 per cent last month. They are still down from last year's high of 3.36 per cent.

Traders had been bracing for a rout in China bonds since March after a larger-than-expected quota for the sales of local government debt was announced at the National People's Congress. The reckoning didn't come in April or May as municipal governments drew on leftover funds from previous debt sales, and the annual tax season saw less funds being withdrawn than expected.

That's all changing in June, with the unusual increase in the overnight interbank repurchase rate, defying the established pattern of weakness at the start of the month. At the same time, municipal authorities are expected to double debt issuance this week to nearly 295 billion yuan (S$61 billion) from the previous week.

The overnight repurchase rate jumped to 2.31 per cent on Monday, and was at one stage six basis points higher than the benchmark seven-day gauge, implying the most inverted funding curve since February. More expensive short-term liquidity reduces the attractiveness of borrowing money to invest in government bonds.

The overnight repo rate then fell back 12 basis points on Tuesday to 2.19 per cent. To ease the liquidity tightness, the People's Bank of China is likely to inject cash into financial markets "at an appropriate time", the state-run China Securities Journal said, citing analysts it did not identify.

The strongest headwind for bonds remains the scaling up in local government debt issuance.

There's a decent possibility that monthly net government bond financing may rise about one trillion yuan for some months ahead, Nomura International economists led by Ting Lu in Hong Kong wrote in a research note. Only 26 per cent of net financing has been completed in the first five months of 2021 and Beijing is likely to require local governments to fulfil most of their quota by the end of October, they said.

The bounce-back in local stocks is also seen as a factor likely to push yields higher. The CSI 300 Index has jumped 5.6 per cent in the past month. "Volatility in the money market is probably rising because of the higher bond issuance in the pipeline and strong equity performance," said Tommy Xie, head of Greater China research at Oversea-Chinese Banking Corp in Singapore. That may divert funds away from bonds, he said. BLOOMBERG