SINGAPORE - The yuan is strengthening at the fastest pace in three months as Chinese bonds' near-record yield premiums over US Treasuries draw funds from abroad.

The currency has risen 0.41 percent against the dollar in the past two weeks, its best performance since the period ended May 1, according to the China Foreign Exchange Trade System.

The difference in yields between China's five-year notes and comparable US government debt was at an all-time high of 258 basis points at midday on Wednesday in Shanghai, while the gap for 10-year bonds was a record 144 basis points, based on Bloomberg data going back to June 2005.

The People's Bank of China (PBOC) has raised interest rates three times this year and boosted lenders' reserve-requirement ratios on six occasions, exacerbating a cash crunch that's driving bond yields higher and making local assets more attractive to overseas investors.

US Treasury yields are falling amid signs the economic recovery is losing momentum.

"US Treasury yields have eased on growth concerns, while China remains characterized by a strong GDP outlook, still high inflation and a relatively tight monetary stance," said Delphine Arrighi, a Hong Kong-based rates strategist at Standard Chartered Plc.

"It is an incentive to bring funds into China, which is why the central bank monitors this very closely."

Money inflows

China's currency regulator reiterated a pledge last month to crack down on inflows of "hot money", while official media cited PBOC adviser Xia Bin as saying the nation should tax transfers of funds from abroad.

A strengthening yuan and relatively high returns on local assets encourage investors to seek ways to circumvent capital controls and deter overseas companies from repatriating profits, complicating efforts to tame the fastest inflation in three years.

Chinese consumer prices rose 6.4 percent in June, while those in the US increased 3.6 percent, the biggest gains since 2008.

"The two countries have extremely divergent growth cycles," said Ju Wang, a fixed-income strategist for Asian emerging markets at Barclays Capital in Singapore. "The yield difference is one of the concerns of policy makers and has been officially cited by China as a reason for not hiking rates too aggressively because that would increase capital inflows."

The gap between yields on China's 10-year notes and Treasuries has more than doubled since April, while the spread between five-year notes widened 1.07 percentage points.

Climbing yields

Ten-year bonds in Shanghai yield 4.03 percent, up 0.14 percentage point, from the end of April, according to data compiled by Bloomberg. The rate on similar- maturity US Treasuries has dropped to 2.59 percent.

The yield on China's 10-year notes will slip to 3.6 percent by the end of December, narrowing the gap with Treasuries, as growth and inflation cool in Asia's biggest economy, according to Arrighi. The rate reached 4.11 percent on July 22, the highest level since Feb 14.

Wang said she expects the yield to climb to 4.3 percent by the end of the year as the authorities are unlikely to cut borrowing costs or loosen monetary policy soon.

Bloomberg News