China's foreign exchange reserves, the largest in the world, reached a record US$3.82 trillion last year.

That hoard was once considered one of the notable achievements of globalized China, but in recent years China increasingly feels nervous about sitting on this pile that is still expanding.

After the US rolled out three stages of quantitative easing, some Chinese have learned the hard way how easy it is[Hong Kong Company Formation] for their pile to be considerably depreciated.

Since China seems to have little ability to stop the US government from reducing its indebtedness by pumping liquidity into the global economy, it appears logical for China to reduce its investment in US Treasury notes.

Could China diversify its reserve assets to hedge against holdings in US dollar-denominated assets?

According to Eswar S. Prasad in his "The Dollar Trap: How the US Dollar Tightened Its Grip on Global Finance," despite all its flaws, the much-maligned dollar will remain the ultimate safe-haven currency.

The near collapse of the US financial system in 2008-2009, plus political paralysis and emerging competitors, have fueled speculation about the dollar's displacement as the main reserve currency.

Paradoxically, the turbulence in the financial markets has since played out in a curious and unanticipated manner.

"In contrast, the dollar's position as the foremost store of value is more secure. Financial assets denominated in US dollars, especially US government securities, are still the preferred destination for investors interested in the safekeeping of their investments," the author observes.

As in the past, [Offshore Company Incorporation]the fact that the dollar has survived the latest financial turmoil has allowed the US to continue exploiting its "exorbitant privilege" as the purveyor of the most sought-after currency in the global market.

Consequently, emerging market economies continue to have strong incentives to accumulate massive foreign exchange reserves to insulate themselves from volatile capital flows.

Some advanced countries like Japan have also been intervening heavily in foreign exchange markets to limit the appreciation of their currencies, in order to strengthen their exports.

If anything, the global financial crisis has even changed views about the level of reserves adequate to protect an economy against the spillover from the crisis.

The recent movement in the exchange rate of the renminbi or yuan against greenbacks is also a telling point.

For over one year the Chinese yuan had been gaining steadily against the US dollar, but since early this year it has had a roller-coaster performance when it began to experience sharp falls and fluctuations.

There is speculation that the move may have been engineered by the central bank to shake out hot money, and to boost exports following the release of a batch of disappointing economic data.

Ironically, when countries intervene to resist currency appreciation, it results in growing accumulation of reserves, which need to be parked in safe and liquid assets, [HongKong Richful  - Hong Kong Company Formation, Offshore Company Incorporation]preferably government bonds.

In other words, such intervention ends up reinforcing the dollar's prominence as a reserve asset.

Herein lies the dollar trap, which essentially refers to global dependence on US dollar-denominated assets as a result of the lack of viable alternatives.

With foreign countries' holding large portions in US federal government debt, it is argued that the US can simply inflate away its debts by printing more dollars.

Prasad believes this to be less a danger than generally assumed, for domestic US holders of US debt constitute a powerful political constituency that will push back in case of high inflation.

The book also evaluates the prospects of China's currency displacing the dollar as China continues to grow.

On Monday, the UK and China agreed to work on a clearing and settlement service for yuan transactions in London, following similar agreements between Germany and China last week.

These agreements show growing European interest in the Chinese currency as the internationalization of the yuan deepens.

Prasad believes that while dollar is likely to become less important as a medium of exchange for intermediating international transactions and settlements, its position as a store of value remains secure, as least for the foreseeable future.