China Money: Commercial paper gears up for tighter liquidity

* Commercial debt supply shifts down the curve

* Investor demand shrinking on risk of policy shift

* Inversion of primary/secondary yields to continue in 2010

By Karen Yeung

SHANGHAI, Nov 19 - Trading in commercial debt over the past month suggests banks are preparing for the possibility of much tighter liquidity, with the economic recovery looking sustainable and longer-term inflation risks expected to rise.

Supply has shifted down the yield curve in recent months to the short-term commercial paper market from medium-term notes, while yields in the secondary markets have surged far above the primary markets for both sections of the curve.

These shifts are the clearest signs in China's debt markets that loose monetary policy is expected to be unwound in coming months, despite the authorities' continued insistence -- most recently in a central bank statement after last week's economic data -- that they will stick to a loose policy stance and keep sufficient liquidity in the banking system. [ID:nPEK347415]

"Liquidity is expected to tighten, so people don't want to invest in commercial paper. The primary and secondary market yields are likely to stay inverted into next year," said Shi Lei, analyst in Bank of China Beijing.

Chinese commercial paper has tenors of up to one year and is generally used by companies to buy materials or manage working capital, while medium-term notes are used primarily to finance long-term investments.

But firms are shifting from medium-term notes to shorter-term commercial paper as expectations for an eventual unwinding of ultra-loose monetary policy have caused a sharp steepening of the yield curve, hiking firm's fund-raising costs in longer tenors.

Commercial paper issuance rose to 160.2 billion yuan ($23.5 billion) in the third quarter from 57.4 billion yuan in the second, while medium-term note issuance fell to 132.7 billion yuan from 275.4 billion yuan, according to a third-quarter bond report by the National Association of Financial Market Institutional Investors , a unit of the central bank.

YIELD INVERSION

The swelling supply is fuelling a rise in secondary-market yields for commercial paper, which have climbed above the yields for newly issued paper and are expected to stay there.

The issue yield for AAA-rated commercial paper is about 2.50 percent, below the indicative secondary market yield <0#AAACNCPFBMK=> of 2.5525 percent bid on Wednesday, according to Reuters Reference Rates.

Traders expect the secondary market yield to rise to 2.80 percent in coming months even as central bank bill yields have remained relatively steady.

The central bank has kept the yield on its one-year bills at 1.7605 percent for 13 auctions in a row.

The supply of commercial paper issuance has also expanded as borrowing shrank in the discounted bills market due to tightened regulatory supervision of banks' new loans, as the government clamped down after an unprecedented lending spree in the first half raised fears of asset price bubbles and rising bad loans.

New lending dropped to 1.28 trillion yuan in the third quarter from 2.79 trillion yuan in the second quarter.

"Expectations for liquidity to tighten as the supply of commercial bills rises have begun pushing commercial paper yields in the secondary market above the primary market," said a trader at a mid-sized bank in Shanghai.

This would saddle investors with a loss if they bought bills in the primary market at a low yield and sold them at a higher yield in the secondary market.

Primary yields have been depressed because big Chinese companies, which enjoy a great deal of clout from the ancillary lending business they provide to banking underwriters of securities, have been able to resist rises in issue yields. Meanwhile secondary yields will get a further temporary boost at the end of the year because banks, the main investors in commercial paper, want to avoid investing in credit debt near the year-end, to dress up their books and produce a higher capital adequacy ratio.

The government is moving to tighten capital requirements to ward off risks linked to this year's heavy lending.

In a recent research note, Shenyin and Wanguo Securities forecast the AAA-rated one-year commercial paper yield would rise to about 3 percent in three months, assuming that the central bank would engineer a rise in the auction yield of its one-year bills to a range between 2.25 and 2.50 percent.

The rise in secondary yields has spurred official efforts to boost primary yields.

Late last Friday, NAFMII, the market association, raised its guidance for minimum yields on commercial paper and medium-term notes to avoid excessively low rates and to attract investor demand in the primary market, after the gap widened with the secondary market. [ID:nSHA161385]

"NAFMII may continue guiding issuance yields higher in coming months under expectations for unwinding of monetary policy," said Lin Chaohui, analyst at Guotai Junan Securities.