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Asia Has 'No Solution' to Dollar Reserves Problem

Even as the U.S. grapples to bring its debt under control, Asia has another problem on its hand: surging currency reserves, mostly in dollar denominated assets. If the U.S. loses its Triple-A rating, and Treasury prices drop, these reserves could be badly hit.

Sheet of US one hundred dollar bills
Don Farrall | Digital Vision | Getty Images
Sheet of US one hundred dollar bills

"It's a concern for all these economies - but it's a concern with no solution," Thio Chin Loo, Senior Currency Strategist at BNP Paribas said on Tuesday.

Asian central banks and policy makers have been aware of the problem for some time and have been trying to diversify their foreign reserves away from the dollar, but Thio says the diversification has been only at the margins.

In fact, several countries, including China, have been buying dollars in order to ensure their currencies don't appreciate too rapidly versus a weakening greenback. According to the latest data from the International Monetary Fund (IMF), dollar assets held by emerging and developing economies in foreign reserves actually rose to $1.47 trillion in the first-quarter of 2011 from $1.4 trillion in the last quarter of 2010.

But the need to diversify has been getting stronger. In the latest sign, Korea's central bank said on Tuesday that it has bought 25 tons of gold between June and July - the first purchase in a decade.

But Andy Xie, a former chief economist of the Asia-Pacific at Morgan Stanley and now an independent economist says Korea's move is in vain, and other Asian central banks should think twice before following suit.

"Gold is not a substitute for the dollar - if you buy more the gold, the price will go through the roof, so it really doesn't work," Xie said, adding that there just isn’t enough bullion to support the extent of diversification.

"The whole gold market is only over a trillion dollars, and emerging economies are accumulating that kind of money in a year," he added.

Instead, Xie says Asian policymakers need to allow their currencies to float freely. He predicts that even China will eventually be forced to float the yuan, given the U.S. debt problems.

"What's going on in the U.S. will force China to do something within 5 years. The key to the dollar is China's dependency on the dollar, and China has had this export and investment model, and that model is running out of steam," he noted.

Xie sees China following in the steps of Taiwan and South Korea. Both countries floated their currencies in the 1980s, and allowed full convertibility for trade transactions (current account) but limited convertibility for investment flows (capital account).