China Bond Rally at Risk as Li Growth Call Threatens Debt Flood

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China Premier Li Keqiang and Malaysia Prime Minister Najib Razak News Conference

Li Keqiang.

Photographer: Goh Seng Chong/Bloomberg
  • Move to widen budget deficit target seen boosting issuance
  • Significant expansion of fiscal policy to boost growth: HSBC

China’s eight-quarter-long bond rally is facing the twin threat of increased sales and reduced demand as the nation’s leaders intensify efforts to stimulate growth in the world’s second-largest economy.

A decision over the weekend to widen the government’s fiscal deficit to a record 3 percent from last year’s 2.3 percent will spur a surge in debt issuance that will push up yields, said China Merchants Securities Co. analyst Sun Binbin. Accelerating inflation and a jump in credit that is seen as positive for the economy are other factors that bond investors need to consider, according to Haitong Securities Co.

The Bloomberg China Sovereign Bond Index has risen every quarter since the beginning of 2014, handing investors a return of 20 percent through the end of last year, compared with 7 percent for U.S. Treasuries. The People’s Bank of China has cut interest rates six times since November 2014 and eased reserve-requirement ratios. Record-low interest rates prompted investors to borrow more, driving total debt to 247 percent of gross domestic product in 2015 and 10-year sovereign yields to the least in seven years.

“Given the various pro-growth measures, the economy is likely to stabilize later this year, driving up inflation and weighing on the bond market,” said Wei Taiyuan, an investment manager at China Merchants Bank Co. in Shanghai. “Yields are already very low and challenges to the economy have already been priced in. The bond market will probably trade range bound at best.”

The yield on the benchmark 10-year sovereign note fell 173 basis points in the last two years and touched a seven-year low of 2.72 percent on Jan. 13, ChinaBond data show. The yield on notes due January 2026 climbed one basis point to a one-month high of 2.95 percent as of 12:59 p.m. in Shanghai, according to National Interbank Funding Center prices.

Premier Li Keqiang is trying to resuscitate an economy growing at the slowest pace in 25 years, while seeking to avoid runaway credit expansion that would risk financial instability. Speaking at the National People’s Congress this weekend, he outlined a 6.5 percent to 7 percent growth range for this year, with 6.5 percent pegged as the baseline through 2020. That would be less than last year’s 6.9 percent expansion, which was the least since 1990.

Growing Debt

Central government debt will grow 18 percent this year, up from 11 percent in 2015, while gross municipal bond issuance will jump 63 percent, according to Bloomberg calculations based on budget projections. Local government bond sales will increase to 1.18 trillion yuan from 600 billion yuan last year. This is in addition to about 5 trillion yuan of regional debt due this year that will be swapped into municipal notes. The swap program was 3.2 trillion yuan last year.

“A larger fiscal deficit, both nominal and actual, together with more bond issuance and other innovative fiscal expansionary measures, reflects a significant expansion of fiscal policy,” Qu Hongbin, Hong Kong-based chief China economist at HSBC Holdings Plc, wrote in a note on Monday. “This will provide greater support to the financing needs of infrastructure projects, which holds the key to stabilize growth.”

The nation’s broadest measure of new credit surged to a record 3.42 trillion yuan in January as a seasonal lending binge coincided with a recovery in the property industry. Home prices in Shenzhen, China’s southern business center in Guangdong province, have jumped 52 percent over the past year, while those in Shanghai surged 18 percent. In a report released March 5, policy makers set the M2 money supply expansion target at 13 percent, compared with last year’s 12 percent.

Leverage Risk

Keeping the monetary base target markedly above nominal gross domestic product growth points to a further increase in leverage in the economy which risks raising contingent liabilities for the government, according to Marie Diron, senior vice president at Moody’s Investors Service. The rating firm last week lowered China’s credit-rating outlook to negative from stable.

“A bigger increase in money supply will translate into larger demand for assets, including property and commodities,” said Ji Tianhe, a Beijing-based analyst at Founder Cifco Futures Co. “Among all the choices, bonds are the least attractive, as the current yields are too low.”

— With assistance by Helen Sun

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