HONG KONG/NEW YORK - U.S. private equity firm Blackstone Group LP is in talks with the Shanghai city government to set up a wholly-owned China subsidiary as it prepares to launch a local currency private equity fund, sources said on Thursday.

Shanghai announced last week that the city would soon allow global private equity firms to incorporate locally in China's financial hub so they could launch yuan-denominated funds to invest in Chinese companies.

The Shanghai Financial Service Office, led by the city government, has given strong backing to senior Blackstone executives, hoping the U.S. private equity group could be the first foreign firm to make such a move, said government and financial sources close to the situation.

The sources said it is too early to estimate the size of Blackstone's first yuan fund, but most yuan funds launched by domestic private equity firms are usually between 5 billion yuan ($732 million) and 10 billion yuan.

The Shanghai city government wants Blackstone to be a good example for other foreign private equity firms as Shanghai wants to strengthen its image as an international financial center, said one of the sources.

For Blackstone, this is also a rare and good opportunity to show your long-term commitment to China and take quick action to expand its investments in China further, he added.

Early this year, China's cabinet announced in a series of pro-Shanghai policies that it would support the city's aim to be an international financial center by 2020.

Fu Shan, China representative for Blackstone, which already has a representative office in Beijing, declined to comment. The sources declined to be identified because they were not authorized to speak to the media.

Blackstone's Greater China Chairman Anthony Leung, a former Hong Kong Financial Secretary, said in November the group would not slow its investments in China despite the global financial crisis, as high economic growth and low valuations promised good returns.

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China has at times been at odds with global private equity firms, thwarting moves by foreign investors that have vied for stakes in industries deemed to be strategically sensitive.

But Beijing has pledged since late last year to develop yuan-denominated funds, often run by domestic managers, to reduce companies' dependence on bank financing amid the worsening global credit crunch.

This will be a very popular trend for foreign funds to come to Shanghai, set up your office and raise your first yuan fund soon, said Jay Chen, founding partner of industry researcher ChinaVenture in Shanghai.

The yuan is becoming a very strong currency these days; liquidity in China is very ample and investment demand is also high. These are all good reasons for foreign firms to come to China to launch yuan funds, he added.

Yuan-denominated funds are also expected to let foreign investors secure approval for deals more easily due partly to not needing the conversion and supervision of foreign exchange issues, industry experts have said.

Besides Blackstone, foreign early birds for such a move included U.S. venture capital giant Sequoia Capital, which last year raised about 1 billion yuan for its first yuan-denominated venture capital fund to focus on small China deals.

The new Shanghai rules to allow foreign private equity funds to incorporate locally are expected to permit such foreign investments in a wide variety of domestic industries, according to a recent research report by law firm Dechert LLP.

If foreign private equity and venture capital can succeed in Shanghai, the domestic industry should also indirectly benefit, Dechert's Basil Hwang and Michael Hickman said in the report.

($1=6.833 Yuan)

(Additional reporting by Samuel Shen in SHANGHAI, Editing by Ian Geoghegan)

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