DEMAND at China's government debt sales was the weakest in at least a year in July as higher reserve-requirement ratios left financial companies with fewer funds to invest in the securities.

The Finance Ministry's offering of seven-year bonds attracted the smallest amount of bids relative to what was available since last August, while the bid-to-cover ratio for the 10-year auction was the lowest since June 2008, according to data compiled by China International Capital Corp. Sales of 182-day bills and three-year notes in the first half of July failed to raise as much money as planned.

"The cash shortage has driven investors to despair," said Guo Caomin, a bond analyst at Industrial Bank Co in Shanghai. "The market is deeply concerned about cash supply in the medium- and long-term. The situation will hardly improve this month as redemptions of central bank bills remain low."

Chinese policymakers are pushing up borrowing costs and draining funds from the financial system to help damp inflation, which hit a three-year high of 6.4 percent last month. President Hu Jintao said on July 21 that stabilizing prices will be a priority in the second half, after the People's Bank of China, the central bank, raised interest rates five times since September and lifted the amount major banks have to set aside as reserves to a record 21.5 percent, from 17 percent.

The sale of 10-year bonds on July 20 attracted orders for 1.40 times the 30 billion yuan (US$4.7 billion) of notes on offer, while the bid-to-cover ratio at a July 6 sale of seven-year debt was 1.56.

Money rates

The most recent United States Treasury auctions recorded bid-to-cover ratios of 3.17 times for 10-year bonds and 3.22 times for three-year notes, even as lawmakers failed to reach an agreement on a debt-ceiling increase needed to avoid a default.

China's seven-day repurchase rate, a measure of interbank funding availability, averaged 5.26 percent in July and 5.90 percent in June, the highest levels in Bloomberg News data going back to January 2004. The rate rose seven basis points, or 0.07 percentage point, to 5.15 percent last Friday, the biggest increase in a week, according to a daily fixing published by the National Interbank Funding Center.

"Big banks are unwilling to lend money as monetary tightening hasn't eased, and this has led to a rapid jump in money-market rates," said Jiang Xiaozhen, a Shanghai-based bond fund manager at Zhonghai Fund Management Co, which oversees about 15.5 billion yuan in assets. "The cash crunch is the fundamental driver of the auction failures."

The ministry plans to sell 22.7 billion yuan of three-year debt on behalf of local governments today. A July 11 sale of similar notes raised 23.9 billion yuan, less than the 25 billion-yuan target. The ministry also plans to auction 30 billion yuan of five-year bonds this Wednesday and 15 billion yuan of 273-day bills.

Redemptions of central bank debt, which are used to help manage the money supply, will decline to this year's low of 352 billion yuan this month from 372 billion yuan in July, according to Guo at Industrial Bank.

"The record high reserve-requirement ratio is making the financial system extremely vulnerable to any small fluctuations in cash demand," said Hu Hangyu, a bond analyst in Beijing at Citic Securities Co, the nation's most profitable brokerage. "Demand for bonds will remain weak if the seven-day repo rate doesn't drop below 4 percent. If the rate continues to stay at around 5 percent, more auction failures will occur."

Higher yields

The government had to offer higher yields to lure investors to auctions in July. The yield on 10-year notes of 4.06 percent was the highest for that tenor since June 2008.

Seven-year bonds were sold to yield 3.70 percent, compared with 3.59 percent at the previous sale in May. A 20-year issue yielded 4.48 percent, the most since August 2008.

The higher yields also reflect expectations the PBOC will boost interest rates further to cool inflation, which may have reached 6.5 percent this month, Guo said. He predicts borrowing costs will be boosted this month, while Citic Securities' Hu said he expects one interest-rate rise and as many as two increases in reserve-requirement ratios before the end of the year.

The yield on China's 10-year government bonds has risen 18 basis points to 4.07 percent since June 30, poised for the biggest monthly gain since November 2010, said Chinabond, the nation's biggest debt clearing house.

No 'hard landing'

"The 10-year government bond yield may rise to 4.3 percent in the coming six to 12 months because there won't be the hard landing in the economy that some might have expected," said Qiu Xinhong, a fund manager in Guangzhou at Golden Eagle Asset Management Co, which oversees 8.1 billion yuan in assets "China's bonds should hand investors more returns given the economy's strong growth momentum."

The economy, which is second only to the US in size, will expand 9.6 percent this year and 9.5 percent in 2012, according to International Monetary Fund projections released in June. Gross domestic product rose 9.5 percent in the second quarter from a year earlier, outpacing the 9.3 percent growth forecast in a Bloomberg News survey of economists, according to government data released on July 13.

Five-year contracts protecting Chinese government debt against default were unchanged at 87 basis points last Thursday, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market. A basis point equals US$1,000 annually in a contract protecting US$10 million of debt.

The yuan was little changed at 6.4420 per dollar last Friday in Shanghai, near a 17-year high of 6.4375 on July 27, according to the China Foreign Exchange Trade System. The yuan has strengthened 2.5 percent this year.

The seven-day repo will average 4.0 percent this quarter, based on the median of 12 estimates in a Bloomberg News poll. That's almost double the 2.1 percent recorded in the same period of 2010 and compares with a second-quarter level of 4.2 percent that was the highest in data going back to 2004.

"Everyone is asking the question, where on earth does all the money go," said Pang Aihua, a bond analyst in Beijing at China Citic Bank Co, a unit of China's biggest state investment company. "Whether demand for bonds will improve will depend on the cash supply."