Salient to Investors:

William Pesek writes:

Asia sits on almost $7 trillion in currency reserves, much of it in dollars as its central banks engaged in a kind of financial arms race after a 1997 crisis. Asia now has more weapons against market unrest than it knows what to do with and is essentially America’s banker, with China and Japan having the most at stake.

Huge reserve holdings are not a financial strength but a trap that is complicating economic policy making. China has leverage but it is limited. Another US debt-limit tussle would fuel market volatility, strengthen the yuan as the dollar plunges, and result in the loss of tens of billions of dollars in China’s portfolio of U.S. Treasuries.

Leland Miller at China Beige Book Intl said China does not like it, but understands it has no option but to accept the hand it is given.

The yen would surge on another US downgrade – in 2011, a flight-to-quality trade drove huge amounts of capital to Japan.

The more Asia adds to its holdings of US debt, the harder they become to unload. Markets would quake at even the slightest whiff that China or Japan was selling large blocks of their trillion-dollar holdings, so central banks just keep adding to them.

The world has never before seen a greater misallocation of vast resources. When central banks buy dollars, they need to sell local currency, increasing its availability and boosting the money supply and inflation. So they sell bonds to mop up excess money.

At the very least, Asia should stop adding to its dollar holdings and consider ways to bring more of those funds home.

It is in the US’s best interest to keep more of its debt onshore, Japan-style, by attracting greater purchases from cash-rich U.S. companies, thereby making the US less vulnerable to capital flights in the future.

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