June 27 (Bloomberg) -- China's finance ministry plans to sell 1.55 trillion yuan ($200 billion) of bonds to buy foreign- exchange reserves that will be managed by a new investment fund, Xinhua News Agency reported.

The Ministry of Finance is setting up the State Investment Co. that will purchase a portion of the country's record $1.2 trillion foreign-exchange reserves from the central bank to seek higher returns in global markets. The bonds will mature in more than 10 years, Xinhua said today without elaborating.

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. China, the world's second-biggest holder of U.S. Treasuries after Japan, wants the new fund to buy the reserves to take more responsibility for generating returns.

``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'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. 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

The plan was reviewed in a session of the National People's Congress, China's parliament, scheduled to end on June 29. 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 fell 5 basis points yesterday to 4.10 percent, after reaching a four-month high on June 25, according to the China interbank bond market. The yield has risen 1.14 percentage points since the start of March. The price of the 2.93 percent security due February 2014 is 93.33. The China interbank bond market has yet to provide today's prices.

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.

The bond sale may lead to too much supply of 10-year 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 60 basis points, from 39 basis points on Feb. 27. A basis point is 0.01 percentage point.

Absorbing Cash

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 Holdings Plc 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.

China's consumer prices rose 3.4 percent last month from a year earlier. 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 cash.

The bond sale is also aimed at reducing excess funds in the financial system, said Li Yang, who heads financial research at the Chinese Academy of Social Science, at a forum on June 20. This type of bond issue is more efficient at absorbing excess cash from financial institutions than central bank's bills and will substitute for the latter, he said.

The strain on the 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 03:12 EDT