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

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

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

Therefore, foreign speculators should, any day now, dump their dollar denominated assets onto the market, and so bring about the dollar decline that they so fear.

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

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

By plowing more than two thirds of its mammoth foreign currency reserves into US dollar denominated assets, China has gained significant political leverage.

With everyone else buying, selling, and holding dollars, it pays to do the same, since markets in dollar denominated assets will be the deepest.

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.

Japan, China, and other export oriented East Asian economies are indeed eager to keep the value of the dollar relatively high, and their central banks have piled up close to 2 trillion in dollar denominated assets.

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.

Second, China s foreign assets are denominated almost exclusively in US dollars, while its foreign liabilities are denominated mostly in renminbi.

With rebalancing will come a decline in China s surplus saving, much slower accumulation of foreign exchange reserves, and a concomitant reduction in its seemingly voracious demand for dollar denominated assets.

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.

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.

About 800 billion of China s foreign exchange reserves are invested in euro denominated assets.

The actual budget increase cannot be determined simply by noting a change in the dollar denominated amount.

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.

CIC chose to take a significant share in one branch, rather than a small share in the whole group, because doing so offered both a strategic advantage (access to energy resources) and a monetary benefit (investment in dollar denominated assets).

If rich country central banks can buy long term bonds, then emerging country central banks can buy dollar denominated bonds.

In November 2001, the authorities again restructured the public debt, this time exchanging dollar denominated bonds for domestic guaranteed loans.

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

Fewer foreign purchases of US assets again imply a weaker dollar.

Nor is it a unit of account prices of goods and services, and of financial assets, are not denominated in gold terms.

In 1994, Mexico shook the global economy when the extent of its domestic (but dollar denominated) debt in the so called tessobonos became apparent.

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.

Moreover, there may be a financial panic large financial institutions with short term liabilities and long term assets will have a difficult time weathering a large rise in long term dollar denominated interest rates. This mismatch can cause financial stress and bankruptcy just as easily as banks local currency assets and dollar liabilities caused stress and bankruptcy in the Mexican and East Asian crises of the 1990 s and in the Argentinean crisis of this decade.

At the same time, periphery countries held a lot of dollar denominated obligations which they had to repay when they could not roll them over.

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

Furthermore, China should be allowed to convert part of its foreign exchange reserves into assets denominated in the International Monetary Fund s special drawing rights (SDRs).

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.

One can also question how much appetite European investors will display for renminbi denominated financial assets. In the past, demand for such assets has been fed by the expectation that the renminbi will continue to appreciate.

Supported by a dollar denominated line of credit, the EPU s 15 Western European member states established exact dollar exchange rate parities as a prelude to anchoring their domestic price levels and removing all currency restrictions on intra European trade.

International bankers estimate that roughly two thirds of Chinese reserves have been invested in dollar assets.

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

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.

America s foreign creditors would not accept a sharp reduction in their dollar assets real value that debasement of the dollar via inflation and devaluation would entail.

As a result, China s dollar denominated foreign exchange reserves, which account for the largest share of all the foreign holdings of US government securities, will suffer interest rate losses.

While China has taken minor measures to slow the increase in its dollar denominated holdings, it has been unwilling to risk a fully convertible currency for domestic political reasons.

In order to maintain a tight relationship between the renminbi and the dollar, China had to recycle a disproportionate share of its foreign exchange reserves into dollar based 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.

China's government regards the threat of capital losses on its dollar denominated securities as less important than the need to maintain near full employment in coastal manufacturing cities like Shanghai.

China has recycled about 60 of these reserves back into dollar denominated US government securities, because it wants to limit any appreciation of the renminbi against the world s benchmark currency.

And investors with smaller dollar holdings, who can shift to other currencies much more easily than the Chinese, are right to ask themselves whether they should be diversifying into non dollar assets or even shunning the dollar completely.

The principal risk I see today is that being borne by investors in dollar denominated debt and I don t believe they are charging a fair price for what they are doing.