Across The Border

Chinese government bonds to remain under pressure

Some analysts caution that Chinese government bond prices will come under continuing pressure amid rising inflation and other factors in the new year

PUBLISHED : Tuesday, 27 December, 2016, 6:10pm
UPDATED : Tuesday, 27 December, 2016, 10:23pm

China is closing out 2016 on a stronger economic footing, but strains are showing in its financial markets, especially in the government bond market. As Chinese authorities look set to prioritise a weaker exchange rate and a relatively loose monetary policy, inflation is set to rise further and real yields could decline, which will put Chinese government bond prices under further pressure, analysts say.

Chinese government bond futures saw a record drop in prices recently, prompting the People’s Bank of China to inject massive liquidity to stabilise the market.

“A slight tightening of monetary conditions has snowballed into a bond market sell-off, with stresses compounded by official efforts to support the renminbi,” said Mark Williams, chief China economist for Capital Economics in a recent research note.

The People’s Bank of China (PBOC) has tightened monetary conditions, manifest in an uptrend of interbank borrowing costs recently. The three-month Shanghai Interbank Offered Rate (SHIBOR), a measure of yuan borrowing costs among commercial lenders, has risen for 47 consecutive sessions as of Friday, the longest stretch of increases since the end of 2010.

Fears of a further spike in borrowing costs intensified after the US presidential elections, as investors expect the PBOC to act more aggressively to support the yuan in the face of a stronger dollar.

“It [the sell-off in bonds] has been exacerbated by liquidity withdrawals caused by heavy foreign exchange sales by the PBOC as well as by the usual end-year liquidity hoarding by banks,” said Williams.

Another concern is default risk due to leveraged bets by Chinese financial institutions.

As strains in the interbank market declined after the PBOC’s cash injection, bond markets also stabilised in recent days.

However, Jefferies analysts warned investors to watch the long end of Chinese yield curve.

“With real yields plunging, there is little value left in Chinese government bonds in our view,” said Sean Darby Kenneth Chan, and Irene Zhou, analysts for Jefferies in a recent report, adding that inflationary pressures are building up in China and causing bonds’ real yields to fall.

“We recommend that investors should be short Chinese government bonds and long Chinese equities,” they added.

Expectations for rising inflation weigh on bond prices, as higher inflation erodes the purchasing power of the bonds’ future cash flows.

Jefferies analysts expect China’s inflation rate to pick up in 2017.

“A number of inflation indicators are turning in China, as well as export price indices,” they said.

Both the producer price index (PPI) and consumer price index (CPI) have risen significantly. In November, the PPI jumped 3.3 per cent from a year ago, reflecting the highest in five years. The CPI rose 2.3 per cent for the month, exceeding forecasts.

Meanwhile, the weaker yuan has led to an increase in prices for imported goods.

This combination, alongside deflation base effects disappearing from 2015, has caused export price inflation to “almost turn positive”, Jefferies analysts said.

“All other things being equal, China will start exporting inflation from 2017,” they added.

In a separate note earlier this month, Jefferies analysts said Chinese authorities are following the classic “impossible trinity” by closing the capital account as the Federal Reserve looks poised to move up rates more aggressively.

The impossible trinity refers to the economic concept which states that it is impossible to maintain an open capital account, a flexible exchange rate, and an independent monetary policy at the same time. Monetary authorities should only ever attempt to manage two of the three variables at any one time, according to economists.

China wants to support the economy via low interest rates low and a soft currency. However, with real rates turning negative, savers naturally want to take their capital of the country. Chinese authorities has tightened capital controls to stem outflows.

“With SHIBOR rising and Chinese repo rates [repurchase agreement rates] flat, it would seem that the authorities are content to prioritise a loose monetary policy and a weak exchange rate,” Jefferies analysts said.

With money supply rising rapidly and commodity prices climbing, China’s inflation rate in the first quarter of 2017 is likely to trend higher, they added.

In addition, Chinese authorities are set to tighten rules on wealth management products sold by banks. These regulations may also hurt the bond market.

Around 56 per cent of wealth management products are invested in bond and money market funds, according to the China Banking Wealth Management Registration System.