Diversification away from dollar assets is the advice of the day.

As a result, holders of dollar denominated assets should be looking forward to two alternative scenarios.

And that raises serious questions about the wisdom of China s massive investments in dollar denominated assets.

In neither scenario does it make sense to hold huge amounts of dollar denominated assets today.

With US government debt repayment now in play, the very concept of dollar based riskless assets is in doubt.

But interest rates on dollar assets are given in world markets independently of what China does.

If they perceive that the dollar and dollar bonds have become riskier, they will want to change the distribution of assets in their portfolios.

But China will do so by providing stimulus to internal demand, thereby weaning itself from relying on dollar based assets.

One might think that foreign investors would quake in terror at these terms and shy away from dollar denominated assets.

A reluctance of foreign investors to keep accumulating dollar assets will cause a smaller capital inflow from the rest of the world.

If progress is not made in reducing the projected fiscal imbalances and limiting the growth of bank reserves, reduced demand for dollar assets could cause the dollar to fall more rapidly and the interest rate on dollar securities to rise.

That will sharply reduce the pace of foreign exchange accumulation and cut into China s open ended demand for dollar denominated assets.

If that feeling is widespread, the value of the dollar and the price of dollar bonds can both decline without any net change in the holding of these assets.

Thus, the market can establish the necessary interest differential only if interest rates on yuan assets fall below their dollar equivalents.

Reserve holdings of dollar assets (primarily by central banks) were worth around 2 of US GDP in 1948 and about the same in 1968.

In a liberalized capital market, the undiminished risk that the yuan might appreciate means that investors must be compensated by a higher interest rate on dollar assets.

So, although dollar bonds and, increasingly, dollar equities are a large part of these countries sovereign wealth accounts, most of the dollar securities that they hold are not needed to finance trade imbalances.

To diversify away from US dollar assets while maintaining its effective dollar peg, China started to buy Japanese yen and South Korean won, hurting their competitiveness.

All of this spells lasting damage to the credibility of Washington s commitment to the full faith and credit of the US government. And that raises serious questions about the wisdom of China s massive investments in dollar denominated assets.

They continue to hold very large positions in dollar denominated assets, which they would not do if they thought the US faced a choice between a cheap dollar and a deep depression.

European and other international banks had acquired a lot of dollar denominated assets which they habitually funded in the interbank market as the market dried up, they were forced to buy dollars.

Finally, investors are adding nearly a trillion dollars worth of net dollar securities to their positions every year, thus increasing the risk of continued dollar accumulation.

Most of these funds are now invested in dollar securities.

So the good news is that dollar investments are safe.

Second, the costs of the insurance premium the outsize, largely dollar denominated reservoir of China s foreign exchange reserves have been magnified by political risk. With US government debt repayment now in play, the very concept of dollar based riskless assets is in doubt.

For starters, the world s investors declared loud and clear in 2008 that they were not concerned about the sustainability of US deficits. When the global financial crisis erupted, they flooded into dollar assets, even though the crisis originated in the United States.

Yet the typical investor in dollar denominated assets whether a rich private individual, a pension fund, or a central bank has not taken the steps to protect themselves against the very likely dollar decline in our future.

And that is true here as well performing the role of reserve currency enables the US to borrow on the cheap, but at the cost of any significant influence over the exchange rate, which is determined by the rest of the world s demand for dollar assets.

The issuance of dollar bonds was a major source of abuse, with speculators buying dollar debt at the official exchange rate, selling it for greenbacks, and then exchanging them for bolivars at a much higher rate on the black market.

If foreign holders of dollar bonds become concerned that the unsustainability of America s situation will lead to higher interest rates and a weaker dollar, they will want to sell dollar bonds.

A distinction is drawn between realized gains and losses resulting through the conduct of transactions in other than United States dollars and gains and losses resulting from the re statement of non United States dollar assets and liability values to an equivalent dollar value as at 31 December 2004.

If the PBC started to buy non dollar assets in large quantities, it would invariably need to convert some current dollar assets into another currency, which would inevitably drive up that currency s value, thus increasing the PBC s costs.

But positive net assets are not sufficient to eliminate financial risk, which also depends on asset structure (the liquidity of assets and the alignment of maturities of assets and liabilities).

Inflation in the US or Europe would reduce the purchasing value of the dollar bonds or euro bonds.

The Incredible Vanishing Asset

The agreement was also signed by the Acting Minister of Finance, Solicitor General and Acting Minister of Justice and was approved by the Vice Chairman as Acting Chairman of the NTGL, since the Chairman was away on a county visit.

Asset purchases have no balance sheet effect, because assets replace money.

That predictable dollar decline makes the relative return on holding dollar bonds even lower than the interest rate differential alone implies.

That means that, over time, these governments will seek to diversify their portfolios, moving away from the current dominance of dollar investments.

Unless the renminbi falls in value, this translates into an average nominal increase of at least 10 11 in dollar terms.

Although individual foreign investors can sell the dollar securities that they own, they can only sell them to other foreign investors. As long as the US has a current account deficit, the stock of foreign owned claims on the US economy must rise.

The problem is that foreign holdings of dollar securities are no longer primarily foreign exchange reserves in the traditional sense.

Assets freeze

(iii) Suspension pursuant to rule 110.2.

They will be passed on.