After the Party Congress finished in October and China’s centrally planned markets were released (somewhat) from the vice-like grip which had prevailed during the proceedings, we noted the comment from Huachuang Securities that China’s bond holders may be about to get hit by “daggers falling from the sky”, referring to deleveraging. They were right, to some extent, as first the government bonds, then corporate bonds sold off during November. This was driven by the authorities tightening credit conditions and redemptions in Wealth Management Products, which led to some unravelling in the latter Ponzi scheme. However, as Bloomberg explains, another factor has been at work, a rise in short-selling, which might not please the central planners.
While the nation’s debt market has no official measure of short sales, analysts say a surge in bond lending has been partially fueled by rising bearish bets. A record 1.82 trillion yuan ($274 billion) of notes has been lent out this year, 18 percent more than the total for all of last year, according to clearinghouse ChinaBond. Short sellers profit from falling bond values by selling borrowed notes and buying them back after prices fall.
“This creates a vicious feedback loop — when institutions think bonds will fall, they borrow and sell, causing a plunge in the securities, which then drags futures down, and thus there’s more shorting,” said Wang Wenhuan, an analyst at Huachuang Securities Co. in Shanghai. “As investors are still quite cautious, there will likely be more bond borrowing in the near term as yields climb.”
As Bloomberg notes, not all bond borrowing is used for short-selling, it can be used to access funding in the repo market.
Still, not all bond borrowing is for shorting. It’s also used by traders seeking financing when cash supply is tight. For example, a financial institution could lend out its corporate bonds in exchange for more liquid government notes, then pledge them in the repo market for funding, according to Becky Liu, head of China macro strategy at Standard Chartered Plc.
However, the consensus seems to be that it’s largely for short-selling, especially as banks can’t sell via derivatives…
Market participants have borrowed 960 billion yuan of sovereign bonds and 710 billion yuan of policy bank notes this year. They like such securities for short selling and hedging because they’re the most liquid, said David Qu, a market economist at Australia & New Zealand Banking Group Ltd.
The amount of overall bond lending started picking up late last year, when policy makers began intensifying their deleveraging campaign. Financial institutions borrowed 170 billion yuan of notes every month on average in the past year, compared with 92 billion yuan in 2015, when the bond market was stronger.
Commercial banks may be borrowing securities to short, rather than selling government bond futures, because they aren’t allowed to trade the derivatives.
…recent examples of bond sell offs point towards heavy short-selling.
Several recent cases suggest short sales may have exacerbated losses. On Nov. 22, when the yield on China Development Bank’s 10-year debt surged to a high of 5.04 percent for the year, traders more than doubled their borrowing of policy bank bonds from the previous day. A similar jump in borrowing occurred amid a selloff of sovereign notes on Oct. 30.
“The increase in bond borrowing undoubtedly shows the market expects the yields to climb further,” ANZ’s Qu said. “We still think the yields will rise, so against this background, the transaction volume of borrowing could continue to climb, accelerating the drop in bonds and even resulting in some overshooting.”
Having broken the 4.0% level in November, the benchmark 10-year Chinese government bond yield has retreated in recent days to 3.92%. This is 86 points higher than the level it started the year and is the worst sell-off since 2013. Bloomberg notes that although “Chinese regulators have a history of clamping down on bearish wagers in the stock and currency markets, they haven’t taken any major measures to curb short-selling of bonds”. If none are forthcoming, we expect to see more of the cascading sell-offs in Chinese government bond, corporate bond and equity markets that were a feature of trading in November.