America's recovery and continuing woes in Europe cited as reason

China, the biggest creditor to the United States, increased its holdings of US Treasury bonds by 2 percent in May to $1.32 trillion, even as foreign demand for the bonds fell for a second consecutive month, according to the US Treasury.

A US dollar note (L) and a Chinese yuan banknote are seen through a pair of spectacles in this file picture illustration taken on October 13, 2010. [Photo / Agencies]

China had increased its holdings of US bonds by 1.6 percent in April, which was revised higher after an initially 0.4 percent drop. Japan, the second-largest buyer, trimmed its holdings 0.2 percent to $1.11 trillion in May.

Experts say that the recovering US economy and the continuing European sovereign debt crisis contributed to China's increased purchase of US debt.

Guo Feng, a senior economist with Washington-based Institute of International Finance, said that "an improving economy in the US, coupled with the anticipation of the Fed 'tapering' of bond purchases" led to the purchases by foreign investors, including China.

Guo predicted that the US will likely post its smallest annual deficit since the financial crisis began in 2008.

"In fact, China has been a large and stable source of demand for US Treasuries, which has contributed to its low and stable yields in the past years," Guo said.

"Given the recovery in the US and sluggish economic growth in Europe, I expect China to continue to buy US Treasuries in the coming months," he added.

US residents increased their holdings of long-term foreign securities, with net purchases of $27.2 billion, while foreign investors decreased their holdings by $39.2 billion, said the Treasury report.

The sum total in May of all net foreign acquisitions of long-term securities, short-term US securities, and banking flows was a monthly net of $56.4 billion, said the Treasury Department. Net foreign private inflows were $46.6 billion, and net foreign official inflows were $10 billion.

Sohpii Weng, an economist for global research at Standard Chartered Bank in New York, said that the yield on 10-year Treasury notes surged by 49.9 basis points in May, as many speculate on the Federal Reserve's move on "tapering" off its $85 billion-a-month bond-purchase program, or the so called quantitative easing 3.

"However, current levels may remain attractive to central banks, which normally have longer-term investment strategies compared to most private investors," said Weng.

"Considering that China remains the US' second-biggest trading partner, in context of a US dollar-positive environment with the Federal Reserve expected to start reducing QE later this year, dollar assets like US Treasuries are likely to remain targets for central banks, including China," said Weng.

"Emerging-market central banks have appeared to stay defensive in the second quarter, focusing on boosting US dollar and selected Asia excluding Japan allocations amid China's slowdown and given the Fed's tapering prospects," she added.

Markets didn't react drastically on Monday when China posted its second quarter growth rate of 7.5 percent - 0.2 percent lower than the first quarter.

On Wednesday, Federal Reserve's chief Ben Bernanke will give his semi-annual testimony before Congress, where he is expected to reinforce his previous remarks on "tapering".