(Adds economist comment, context background)
By Weihao Cao and Gabriel Wildau
BEIJING/SHANGHAI Jan 22 (Reuters) - German automaker Daimler AG will become the first foreign, non-financial company to issue bonds in China's domestic market, two sources close to the deal told Reuters on Wednesday.
The deal marks an important step in China's gradual campaign to reform its financial system and could pave the way for other non-Chinese firms to tap the world's third-largest bond market behind the United States and Japan.
For the Stuttgart-based automaker it is a breakthrough in its efforts to mitigate currency risk and diversify its sources of funding to reduce dependence on bank loans.
Daimler is currently investing to overhaul its factories in China, the world's second-largest economy, to equip them for production of the new Mercedes' C-class sedan for Chinese customers..
Daimler can now sell the so-called panda bonds in local financial markets, adding fixed income as a source of funding to the bank loans currently used as the main way to refinance a large part of its Chinese business.
"It's Mercedes-Benz's parent company selling panda bonds, but details like the date of the auction aren't set yet," said one of the sources, who spoke on condition of anonymity because the plan is not yet public.
Daimler manufactures Mercedes-branded vehicles in China through its joint venture with BAIC Motor, the passenger car unit of state-owned Beijing Automotive Group. It also imports cars to China which were manufactured in Germany.
Market watchers expect robust demand for Daimler's bonds, due to the company's strong credit rating and prestigious brand.
A Daimler spokesman declined to comment.
As part of its broader reform push, Beijing has pledged to ease restrictions on the flow of investment funds into and out of the country.
Though Daimler is likely to use the funds raised from selling bonds in its Chinese operations, other foreign issuers could eventually win permission to move funds raised in China to other locations.
Previously, the only foreign entities to issue panda bonds were state-backed financial institutions, including the Asian Development Bank, the Japan Bank for International Cooperation, and the International Finance Corp., the private-sector investment arm of the World Bank.
A few locally incorporated subsidiaries of foreign-invested firms have issued bonds in China's domestic market. But the sale by Daimler will mark the first non-financial issue by a firm incorporated outside China.
Chinese and foreign firms have also issued yuan-denominated dim sum bonds in Hong Kong in recent years. Unlike domestic bonds, dim sum issues are not subject to approval by Chinese regulators.
"It's a positive step towards capital liberalisation. But overall the strategy is to take a gradual approach. In the near term, I don't expect the scale (of bond sales by foreign firms) to expand very quickly," said Zhu Haibin, chief China economist for J.P. Morgan in Hong Kong.
Bonds outstanding in China's domestic interbank market, where Daimler will sell its bonds, totaled 27.6 trillion yuan ($4.6 trillion) at the end of November, central bank data shows.
Non-financial corporate bonds account for about 9.3 trillion yuan of that total, with the government and financial institution bonds accounting for the rest. Another 1.8 trillion yuan in bonds are traded on China's stock exchanges.
Zhu compared the move to steps taken last year to allow foreign investors to purchase bonds in the interbank market through the Qualified Foreign Institutional Investor (QFII) program, which was originally limited mainly to stocks.
"They're trying to expand the market from both the demand and supply side," he said.
Bank of China will be the sole underwriter on the deal, the sources said. The bank declined to comment.
($1 = 6.0505 Chinese yuan) (Additional reporting by Norihiko Shirouzu and Edward Taylor; Editing by Shri Navaratnam and Erica Billingham)