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Abu spent last season at Norweigan outfit, Stromsgodset, making 35 appearances for the team.
“We think this will be a good move for the player, great experience and a fantastic chance for him to play regularly and get back into the Ghana national team,” said boss Roberto Mancini.
“Mohammed has done well on loan and is a good player with good potential. He will be playing in a top league with high class players.”
With four Ghanian caps to his name, the 20-year old is a highly rated midfielder who was a part of his country’s African Cup of Nations squad for last year’s tournament.
A tenacious, uncompromising player, Mohammed made a big impression in Norway last year, winning a host of admirers thanks to his athleticism, positional discipline and eye for a long range strike.
Abu signed a new long-term contract at City in October 2011 and scored his first goal in professional football shortly after with a 35-yard screamer for Stromgodset against Songdnal
A delighted Abu told mcfc.co.uk at the time, "I'm so happy to get a new contract, and to see that the club have a lot of faith in what I've done. I am working towards the day when I can wear a Manchester City shirt in a first team game."
Rayo Vallecano are widely regarded as Madrid’s third biggest side. Last season Los Franjirrojos finished 15th in their first year back in La Liga since 2002/03.
Rayo play in the 15,500-seater stadium Campo de Futebol de Vallecas.
Everyone at Manchester City would like to wish Mohammad all the best for the season ahead.