US GSE troubles could dampen China buying - Merrill

NEW YORK, July 28 (Reuters) - China will be more cautious in the near term buying U.S. agency debt like that of Freddie Mac (FRE.N) and Fannie Mae (FNM.N) given the recent troubles at the two mortgage finance giants, Merrill Lynch said in a report released on Monday.

However, China is not expected to dump any of its U.S. agency debt holdings in the near future, and could even add to its holdings of U.S. Treasury debt due to a rapid rise in its foreign exchange reserves, Merrill said in the report.

As of June, China was the largest single holder of U.S. agency debt, and is one of the world's largest overall holders of U.S. securities.

China has come under "tremendous" pressure from the government, media and academia regarding its agency holdings, Merrill said. On Saturday, the U.S. government approved a housing market rescue bill that offers emergency financing to Fannie and Freddie and which will create an new regulator for the two.

"We believe China won't dump those agencies in the near future, but will be much more cautious in making new purchases," Ting Lu and Steven Lam, Hong Kong-based analysts for Merrill, said in the report.

"In the near term, due to rapid increase in foreign exchange reserves and the lack of low risk and liquid alternative investment opportunities, China may even add more US Treasuries," they said in the report, adding "in the medium to long term, we expect a faster shift of foreign exchange reserves to non-U.S. dollar-based assets with a wider asset class selection."

Merrill said China's holdings of long-term agency debt jumped by more than seven times in the six years from 2002 to May 2008 to $438 billion, which is 24.4 percent of China's foreign exchange reserves and 29.5 percent of total U.S. agency debt held by foreign investors.

"Since China sits on the world's largest foreign exchange reserves and is taking in $25 billion in trade surplus and foreign direct investment per month this year, China's changing mind-set on asset allocation could have a noticeable impact on global bond yields and exchange rates," Lu and Lam said in the note. (Reporting by Chris Reese: Editing by Diane Craft)