China Money: Market gears up for deflation

By Karen Yeung

SHANGHAI, Nov 19 (Reuters) - Months after coping with the highest inflation in more than a decade, China's money market is gearing up for a fresh shock: deflation.

The risk of consumer price inflation turning negative early next year looks set to leave the market awash with idle funds, crush the upward slope of China's bill curve, and push banks into buying bills at yields below their market funding costs.

"Market expectations for aggressive monetary easing will strengthen even further because of serious deflation in producer prices early next year. Deflation could have a bigger impact on the economy than inflation," said Xing Ziqiang, analyst at investment bank China International Capital Corp (CICC).

Early this year, talk of deflation in China would have seemed absurd. Consumer price inflation hit a 12-year high of 8.7 percent in February, propelled by rapid economic growth and surging global prices of oil and other commodities.

But the global economic crisis has reversed the trend. Chinese inflation tumbled to a 17-month low of 4.0 percent in October and is expected to keep falling; CICC predicts inflation of just 1 percent early next year and says it could turn negative, depending on movements in food prices.

Deputy central bank governor Yi Gang said last week that the focus of both monetary and fiscal policy next year would be to avert the threat of deflation.

FALLING PRICES

China is no stranger to deflation; consumer prices fell 0.8 percent in 2002, 1.4 percent in 1999 and 0.8 percent in 1998.

But more is at stake for the money market this time. Rapid growth of the banking system, reforms such as the introduction of interest rate derivatives, and rising debt issuance have boosted trading volume in the interbank bond repurchase market more than fivefold since 2002.

Bill market trading over the past few days suggests banks have actively started preparing for the possibility of deflation.

The indicative secondary market yield on the central bank's one-year bills CN1YNFIX=R slid to a 29-month low of 2.3290 percent on Monday, for a drop of 67 basis points since the start of this month, Reuters Reference Rates show.

That brought it well below the seven-day bond repurchase rate CN7DRP=CFXS, a key funding rate for banks, of 2.70 percent -- showing some banks have abandoned their traditional yardsticks for gauging the value of bills, as expectations for further falls in bill yields make them desperate to buy at current levels.

Over the previous two years, the one-year bill yield had generally stayed about 100 bps above the seven-day repo rate, except during brief funding squeezes caused by large initial public offers of equity.

"Traders are eager to buy safe-haven central bank bills, even if that means accepting lower yields than repo rates, because they're pricing in deflation," said a trader at a European bank in Shanghai, who declined to be named because he was not authorised to speak publicly to media.

In the last few weeks, China's central bank has followed its overseas counterparts by injecting large amounts of funds into the money market, as it seeks to encourage banks to lend to companies, ease jitters over counterparty risk, and prepare the market to absorb big bond issues that are expected to fund the country's economic stimulus package.

The central bank has started to auction its three-month and one-year bills on alternate weeks, rather than every week, in order to inject more liquidity. Some traders think it could soon halt bill issues entirely, which could accelerate banks' scramble to buy scarce bills from the secondary market.

FALLING RATES

Traders don't think China's central bank will go nearly as far as the Bank of Japan did in fighting deflation early this decade, when short-term Japanese interbank lending rates were effectively brought down to zero.

China didn't resort to zero rates during its previous periods of deflation, and after this month's announcement of a nearly $600 billion economic stimulus package for the next two years, it is clearly counting on fiscal policy to support growth.

But traders see ample room for yields to fall further as China continues a monetary easing cycle that began in September.

The trader at the European bank predicted the one-year bill yield would fall to 2.0 percent by the end of this year, with the seven-day repo rate sinking to 2.4-2.5 percent.

Further falls will become likely, with the negative spread between the two rates widening further, if deflation does materialise, he said.

With the market flooded by money and new bill issues suspended, the bill curve out to one year could become almost perfectly flat, some traders think. The spread between one-month CN1MNFIX=R and one-year bills has already narrowed to 13 bps, from around 80 bps in the first half of this year.

Bank of China forecasts the central bank will cut commercial banks' benchmark one-year deposit rate, now at 3.60 percent, to 2.52 percent by next June and 1.98-2.25 percent by end-2009.

A cut to 1.98 percent would bring the deposit rate down to its level in 2002, when China last experienced deflation. LINKS: > What is deflation and why is it feared? [ID:nLC189230] (Editing by Andrew Torchia)