Prakash Sakpal, Economist at ING, suggests that with the Chinese proactive fiscal policy becoming more forceful in 2016 a supply overhang from a wider fiscal deficit will be a negative for government bonds this year. Key Quotes “The PBOC day before yesterday scrapped regulations limiting foreign investment in the country’s interbank bond market. The statement on the central bank’s website said that overseas commercial lenders, insurance companies, securities firms and asset managers would no longer need to apply for quotas to invest in the market. China’s is the third largest bond market in the world after the US and Japan. While giving foreign investors free access to the local bond market is a step in the direction of internationalizing the Yuan, we think its immediate intent is to stem the current outflow of confidence sensitive capital. In another news, the head of PBOC’s statistics department Sheng Songcheng said in an article published by The Economic Daily that the government’s 3% warning line for budget deficit didn’t fit with China’s reality and the government could raise the deficit to 4% of GDP or even more to offset the impact of reduced fiscal revenue and need to support broader reforms. The 2015 deficit has reportedly exceeded the 2.3% of GDP target to something like 2.7% (2.1% in 2014). The authorities have indicated that the proactive fiscal policy would continue and become more forceful in 2016. We expect the deficit to rise toward 3% of GDP in 2016 as more fiscal support is needed to support the near-7% GDP growth target. Based on press reports the support is on the way: the target new government bond issuance for local governments in 2016 is set at CNY1tr (1.5% of GDP), up from CNY600bn in 2015 and the local government bond swap is expanded to CNY5tr from CNY3.2tr. A supply overhang from potential widening of fiscal deficit is negative for the bond market. The stock market selloff since last summer has buoyed bonds, though at their current levels local bond yields remain attractive compared to US and Japanese counterparts. Our yearend forecast for the 10-year local currency government bond yield is 2.50% (latest 2.89%, Bloomberg median 2.80%). With China CDS trading through Philippine CDS (138bp vs. 124bp) there is a case that the re-pricing is underway, though such re-pricings typically overshoot and we think this now is the case for China CDS.” For more information, read our latest forex news.