By Denny Thomas and Donny Kwok

France's Danone SA will spend $665 million to lift its effective stake in China's top dairy firm, China Mengniu Dairy Co Ltd as it seeks to boost its presence in one of its most important markets.

The 486 million euro investment by the world's biggest yoghurt maker will see its effective holding in Mengniu rise to 9.9 percent from 4 percent, making it the Chinese company's second-biggest shareholder.

Mengniu's shares rallied as much as 9.5 percent to an all-time high of HK$40.35 before much of those paring gains.

Booming Chinese demand for dairy products has sparked a raft of M&A and IPOs in China's dairy sector. Food safety scares have also boosted demand for foreign baby milk formula, pushing local dairy firms to increase ties with foreign makers.

Sales of dairy products are expected to nearly double from 2012 to 2017 to about $89 billion, according to estimates by business consulting firm Frost & Sullivan.

Danone, the maker of Bledina baby food and Volvic water, formed an alliance with Mengniu in May 2013, under which the companies agreed to produce and sell chilled yoghurt products in China.

Under the new agreement, Danone and COFCO Dairy Investment, a venture with China's state-owned COFCO, will subscribe to a reserved rights issue by Mengniu at HK$42.5 per share, a 15.3 percent premium to Mengniu's previous close.

COFCO, Danone and dairy cooperative Arla Foods, Mengniu's three core shareholders, will combine their stakes within COFCO Dairy Investments, Danone said in a statement. COFCO owns 16.3 percent of Mengniu and Arla owns 5.3 percent.

Danone has long aimed to establish a major presence in China. Its first joint venture with China's largest beverage company, Hangzhou Wahaha Group Co, fell apart in 2009 after 13 years.

China's dairy industry is dominated by local companies including Modern Dairy, China Huishan Dairy Ltd and YST Dairy. Foreign players have taken a significant role in niche markets such as milk powder after a 2008 food safety scandal.

Mengniu shares were trading 1.8 percent higher at HK$37.50 by 0300 GMT, while the Hang Seng index .HSI was up 1 percent.

Mengniu plans to use the proceeds to cut down debt. Deutsche Bank advised China Mengniu, the Chinese company said.

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