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

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

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

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.

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.

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.

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.

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.

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.

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.

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

In the first round of cash infusions, they got about 0.67 in assets for every dollar they gave (though the assets were almost surely overvalued, and quickly fell in value).

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.

(v) Gain loss on exchange arises from transactions conducted in currencies other than dollars (i.e. for the dollar based extrabudgetary technical cooperation activities in annex I, dollar statements) and the revaluation of assets and liabilities held in non dollar currencies.

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

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

The exposure of NII to changes in interest rates can be measured by the dollar maturity gap (DMG), which is the difference between the dollar amount of assets that reprice and the dollar amount of liabilities that reprice within a given time period.

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

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

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

With the US no longer viewed as a supplier of high quality financial assets, one would expect the dollar to have weakened.

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.

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

At present, the world holds a lot of US dollar assets, and greater diversification of portfolios in coming years would not be shocking.

After all, where else would they place their asset bets? Why would they risk losses in their massive portfolio of dollar based 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.

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

In fact, whenever the world looks unstable, investors want to hold more dollar assets even when the US is the cause of the instability.

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

With its anticipated bond purchases keeping a lid on interest rates, the net effect is that investors do not see an adequate real return from holding dollar assets, which is perhaps one reason the dollar has been depreciating.

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.

With slowing world economic growth, US financing needs could cause a drop in investors confidence in the future of US based assets, precipitating a sharp dollar depreciation.

Fully two thirds of that total around 2 trillion is invested in dollar based assets, largely US Treasuries and agency securities (i.e., Fannie Mae and Freddie Mac).

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.

In plain English, a supposedly well capitalized bank in the UK can have 97 cents of debt per one dollar of assets (and just three cents of equity).

So, even if the dollar is still regarded as the safest of assets, the demand for dollars will decline if its relative safety is seen to have declined.

If the dollar has already fallen if nobody expects it to fall much more then there is no reason to compensate global savers and investors for holding US assets.

As a result, whenever the US dollar declines, China s net international investment position (the difference between its external financial assets and liabilities) deteriorates and so does its investment income balance.

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.