Investing in Japanese bonds is safer because so much of the country's debt is held domestically, and the yen is on course to strengthen further, said Zhang Ming, an economist with the Chinese Academy of Social Sciences, a top government think-tank.
Even though the difference in yields is big, China has been abandoning U.S. debt and picking up Japanese debt. This definitely shows that it believes the risks of U.S. debt far exceed those of Japanese debt, Zhang said in a report issued by his research institute.
The report was issued a day after the Federal Reserve said it would buy more U.S. government debt in a form of mild quantitative easing to counter economic weakness.
Top Chinese leaders have previously registered their concerns about lax U.S. fiscal policies eroding the value of their investments in the United States.
A source familiar with China's strategy for investing its foreign exchange reserves said the Fed's decision might, in fact, be well-received in Beijing.
The purpose for the Fed in buying Treasuries is to support U.S. economic growth, which is positive, he said.
Chinese has already bought more than a net 1.7 trillion yen ($19.9 billion) of Japanese debt in 2010, far surpassing its record of 255.7 billion yen in 2005.
At the same time, China has pared back its vast holdings of U.S. debt from $894.8 billion at the start of this year to $867.7 billion as of May, the most recent data shows.
The two-year U.S. Treasury note yield fell to a record low of 0.493 percent on Wednesday. Japan's two-year notes are yielding around 0.135 percent, but all eyes are on the yen, which hit a 15-year high against the ailing dollar.
But Ben Simpfenforder, an economist with Royal Bank of Scotland in Hong Kong, warned against reading too much into China's shift toward Japanese debt.
China's foreign exchange policy is constantly evolving in response to local and external conditions, and today's trends may reverse tomorrow, he said in a note this week.
BETTER RETURNS IN JAPAN
China has long said that it wants to diversify its foreign exchange reserves, the biggest in the world at $2.45 trillion. Analysts estimate that about two-thirds are invested in dollar-denominated assets.
Along with diversification, China's reserve managers say they want to invest in liquid and safe assets and earn a reasonable return.
Japanese debt is a good choice for now on all of these counts, said Zhang from CASS, the government think-tank.
Foreigners hold a third of U.S. debt but only 5 percent of Japanese debt, making the Japanese market structure more stable, he said.
Moreover, Japan's current account surplus and the unwinding of yen carry trades put on before the global financial crisis should continue to push the yen up in the short term, he added.
But Zhang stopped short of calling this a decisive change in China's foreign exchange investment strategy.
The yield on holding Japanese debt is very low, and Japan has a series of systemic problems -- an aging population, high government debt, a liquidity trap -- which influence the mid- to long-term sustainability of Japan's debt, he said.
Whether China can continue to invest in Japanese debt will require closer observation, he said.
Zhang also pointed out that China had not turned its back on the United States. While it cut about $161 billion of its short-term U.S. debt holdings in the 10 months to May, it actually added $88.5 billion of longer-term debt.
The fundamental problem is that China should not be in a situation where it must buy either U.S. or Japanese debt, he said.
The choice between Japanese and U.S. debt is not a choice between good and bad. Rather, it is being compelled to pick between bad and worse, he said.
If China slowed its accumulation of foreign exchange reserves by working to cut its trade surplus and allowing its exchange rate to appreciate, it would not need to invest so much in foreign debt.
This is the only way to get at the root of the problem, he said.
(Editing by Kim Coghill)