June 27 (Bloomberg) -- China's finance ministry plans to sell 1.55 trillion yuan ($200 billion) of bonds as part of a plan to increase returns on foreign-exchange reserves and drain cash from the world's fastest-growing major economy.

The Ministry of Finance is raising the money for the State Investment Co., which will then purchase a portion of the country's record $1.2 trillion currency reserves from the central bank. The plan will help boost returns on those assets and curb ``excess liquidity'' in the economy, Xinhua News Agency reported, citing Finance Minister Jin Renqing.

The sale will add to the supply of China's bonds, which slumped 2.7 percent this year, the worst performing among 10 local-currency debt markets tracked by HSBC Holdings Plc. It may also drive up interest rates, slowing growth in an economy that expanded 11.1 percent in the first quarter.

``It is not clear yet if the bonds will be sold to all investors or only certain targeted institutions,'' said Li Gang, a fixed-income trader at the Agricultural Bank of China, one of the nation's four-largest lenders. ``If sold to the market, it will definitely push up bond yields.''

China, the world's second-biggest holder of U.S. Treasuries after Japan, wants the new fund to buy the reserves so that it can take more responsibility for generating returns. Lou Jiwei, a former vice minister at China's finance ministry, was appointed this year to start up the new investment fund.

Oversupply of Debt

China's outstanding bonds, including government debt, central bank bills and corporate bonds, reached 10 trillion yuan at the end of May, according to the government-run Chinabond Web site.

A resolution on the plan, reviewed by China's National People's Congress, China's parliament, will be put to the vote on Friday. The meeting will also review a plan to remove or reduce a 20 percent tax on interest income, Xinhua said today in a separate report.

The yield on the benchmark seven-year bond rose 3 basis points to 4.14 percent today, according to inter-bank data compiled by Bloomberg. The yield has risen 1.19 percentage points since the start of March. The price of the 2.93 percent security due February 2014 is 93.13.

The market has slumped on speculation the People's Bank of China will raise its benchmark one-year lending rate of 6.57 percent. Central bank Governor Zhou Xiaochuan said at the weekend he can't rule out raising rates again.

Absorbing Cash

Jin said the bonds will have maturities of more than 10- years to give China a more complete yield curve, Xinhua reported.

The bond sale may lead to too much supply of longer-dated debt, Stewart Newnham, a Morgan Stanley currency strategist in Hong Kong, wrote in a June 22 report. He predicts the gap, or yield curve, between interest rates on short and long-dated securities will widen.

The seven-year bond's spread over three-year yields widened to 72 basis points, from 43 basis points on March 2. A basis point is 0.01 percentage point.

Soaking up 1.55 trillion yuan from the system has the same effect as raising China's reserve requirement ratio 10 times with a magnitude of 0.5 percent each, Qu Hongbin, chief China economist at HSBC in Hong Kong, wrote in an e-mailed report.

Should the bonds be issued to the central bank, it would have no effect on liquidity and the financial markets, Qu wrote.

The bond sale will also ease pressure on the central bank to sterilize after buying foreign exchange, Xinhua quoted Jin saying. The People's Bank of China has been buying U.S. currency to limit gains in the yuan, which gained 8.6 percent since July, 2005. It then issues bonds to mop up the yuan it has sold.

Inflation Pressure

China's currency reserves grew at about $1 million a minute in the first three months of this year as exports boomed, flooding the economy with cash9B7IYIV34I1A"></a> Consumer prices rose 3.4 percent last month from a year earlier.

The bonds will replace central bank bill sales because they are more efficient at absorbing excess cash, said Li Yang, who heads financial research at the Chinese Academy of Social Science, at a forum on June 20.

The strain on China's bond market was highlighted by the failure of a debt sale by state-owned China Development Bank last week.

China Development Bank, the nation's biggest bond seller after the finance ministry, failed on June 22 to get enough buyers for an 8 billion yuan asset-backed securities auction.

To contact the reporter on this story: Belinda Cao in Beijing at lcao4@bloomberg.net

Last Updated: June 27, 2007 06:32 EDT