Nov. 10 (Bloomberg) -- China's one-year interest-rate swap rate may return to a discount to the two-year contract by the end of this year as slowing loan growth prompts banks to steer more funds into local money markets, China Citic Bank Corp. said.

One-year swap rates, which are based on the seven-day repurchase rate, exceeded those for two years on Oct. 9 for the first time since 2006, causing a so-called inverted curve. The inversion occurred after the People's Bank of China lowered its benchmark 12-month lending rate twice in October, reflecting bets on a series of cuts, said Guan Jiaying, a Beijing-based fixed- income analyst at China Citic Bank.

Shorter-dated rates may fall as banks will have more money on their hands in coming months, she said.

``Growth in banks' new loans tends to slow down to zero toward year-end, which will release more funds to the money market for lending between finance companies,'' Guan said. Lower deposit rates will lower banks' funding costs, also helping to bring down the one-year swap rate, she added.

China reduced lending rates for the first time in six years in September, followed by two more cuts to both lending and deposit rates last month after the economy expanded at the slowest pace in five years in the third quarter. Since July, the government has shifted its focus to sustaining growth from curbing inflation as the U.S., Europe and Japan teeter on the brink of recession.

More Liquidity

The one-year swap rate ended last week at 2.33 percent in Beijing, higher than the 2.31 percent for the two-year contracts, according to data compiled by Bloomberg. The two-year rate has averaged 9 basis points more than the one-year in the past year. A basis point is 0.01 percentage point.

The one-year swap rate will fall more quickly than longer- dated contracts toward the end of the year as the underlying seven-day repo rate, a measure of money-market liquidity, will decline, Guan said. She predicts the seven-day repo rate will drop to 2.6 percent, possibly this month, from 2.79 percent at the end of last week.

In an interest-rate swap, two parties agree to exchange fixed payments for variable-rate payments over a set period. Typically, one agrees to pay a fixed rate, while the other pays a rate that fluctuates with a benchmark index or formula defined in the contract.

To contact the reporter on this story: Belinda Cao in Beijing at lcao4@bloomberg.net

Last Updated: November 9, 2008 15:26 EST