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Spread Over Treasuries Shrinks as Economy Slows: China Credit

Chinese government bonds’ yield premium over U.S. Treasuries is shrinking at the fastest pace this year as economic growth prospects dim, discouraging capital inflows that stoke inflation and spur yuan gains.

The difference for 10-year notes narrowed 41 basis points this month to 154, after reaching a record 235 a month ago, according to data compiled by Chinabond and Bloomberg. The gap is headed for the biggest monthly decline since December, after widening 122 in the third quarter. China’s 3.74 percent yield compares with 11.96 percent on similar-maturity debt in Brazil, 8.8 percent in Russia and 8.82 percent in India.

The government’s borrowing costs are declining as the weakest economic expansion in two years fuels demand for the safest assets and decelerating inflation fans speculation the central bank will ease monetary policy. Buying yuan in Hong Kong’s offshore market is 0.7 percent cheaper than in mainland China and the currency has traded at a discount in the city for more than a month because of cooling global demand.

“The falling yield premium is the result of worsening growth expectations, which have dropped significantly for China,” said Ju Wang, a Singapore-based senior analyst at Barclays Capital. “Should we continue to see the spread narrow, that would mean growth prospects in China keep softening and lead to fewer inflows.”

Central bank purchases of overseas currencies from the nation’s lenders, a guide to capital inflows, totaled 247 billion yuan ($39 billion) in September, compared with a monthly average of 326 billion yuan this year, official data show. China’s foreign-exchange reserves fell $60.8 billion to $3.2 trillion in September, the first decline since May 2010, while direct investment from abroad grew at the slowest pace in three months, separate reports showed.

Growth, Inflation

The yuan strengthened 0.16 percent today to 6.3740 per dollar as of 10:01 a.m. in Shanghai, after retreating 0.09 percent last week, according to the China Foreign Exchange Trade System. Twelve-month non-deliverable forwards traded at 6.4015, a 0.4 percent discount to the spot rate, data compiled by Bloomberg show. In Hong Kong’s offshore market, the currency advanced 0.12 percent to 6.4180.

The People’s Bank of China raised interest rates three times this year and boosted lenders’ reserve-requirement ratios on six occasions, seeking to rein in an inflation rate that hit a three-year high of 6.5 percent in July. Economic growth slowed to 9.1 percent in the third quarter, from 9.5 percent in the second, and consumer prices rose 6.1 percent from a year earlier in September, according to data released in the last two weeks.

China Bears

China may cut interest rates and introduce a new stimulus plan equal to trillions of yuan should slowing growth become “more serious,” Wang Jian, secretary general of the National Development and Reform Commission’s China Society of Macroeconomics, said in the China Securities Journal on Oct. 18. The economy may cool rapidly as a result of bankruptcies of small- and medium-sized companies through early 2012, Wang said.

“A lot of bears are playing around the China theme,” said Nathan Chow, an economist in Hong Kong at DBS Group Holdings Ltd. “Look at the foreign-exchange market. The appreciation of the renminbi has diminished quite significantly.” The yuan is a denomination of China’s currency, the renminbi.

Government bonds are climbing as stocks slump. China’s 10-year bond yield fell eight basis points, or 0.08 percentage point, last week to 3.74 percent, while the Shanghai Composite Index of shares tumbled 4.7 percent, the biggest loss since May, according to data compiled by Bloomberg.

‘Manageable’ Slowdown

The State Council unveiled measures this month including tax breaks and easier access to bank loans to help small firms, after the collapse of manufacturers in Wenzhou city. The nation’s growth is “sound,” Xia Bin, a central bank adviser, said on Oct. 19, and he doesn’t believe the government will launch “another round of major economic stimulus.” The central bank should stick to its “prudent” monetary policy, he said.

“China is undoubtedly slowing, but at an entirely manageable rate,” Glenn Levine, senior economist at Moody’s Analytics in Sydney, wrote in an Oct. 17 note. “Weaker demand from developed economies will hurt, but market concern about a hard landing appears exaggerated.”

China’s yield advantage over Treasuries is still attractive enough to lure funds as the country’s economy remains resilient, DBS’s Chow said. Gross domestic product will climb 9.5 percent this year and 9 percent in 2012, the International Monetary Fund forecast last month. The U.S. economy is predicted to grow 1.5 percent in 2011 and 1.8 percent in 2012.

No ‘Hard Landing’

“I don’t see any chance of a hard landing in China,” said Chow. “The spread will maintain, which would attract inflows from abroad and the renminbi will continue to have appreciation pressure in a longer-term perspective.”

The 10-year yield gap has averaged 100 basis points this year, almost four times the 28 basis-point spread in 2010. China’s retail sales increased 17.7 percent in September from a year earlier and industrial production grew 13.8 percent, official data showed on Oct. 18, both exceeding the median estimates in Bloomberg surveys of economists.

Five-year credit-default swaps protecting Chinese government debt against default were little changed last week at 140 basis points, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts insure debt against non-payment, and traders use them to speculate on credit quality.

China can still achieve 7 percent to 8 percent economic expansion amid a global recession as the government will be able to fund a stimulus package should it be needed, Yu Yongding, a former central bank adviser, said in Beijing on Oct. 21.

Crash Concern

Investors should prepare for a “hard landing and yuan devaluation,” Albert Edwards, Societe Generale SA’s global strategist in London, wrote on Oct. 20. Excessive investment may mean that the economy “could easily spin out of control and crash,” he wrote.

The average yield on yuan-denominated debt sold in Hong Kong, known as Dim Sum bonds, increased 51 basis points to 3.65 percent this month, according to HSBC Offshore Renminbi Bond Index data.

“Some of the hot money is returning to their native origins due in part to a shortage of liquidity in Europe and the U.S. and as some investors have the concern that China’s economy is slowing,” said Wang Jianhui, an analyst in Beijing at Southwest Securities Co.

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