The foreign exchange market is focusing on the diversification of their reserves. Because the bulk of reserves are in U.S. dollars, diversification means reducing the dollars share of total reserves. As foreign exchange reserves continue to grow, diversification could occur even as dollar- denominated reserves continue to rise in absolute terms.

To be sure, there are concerns that as China and other countries in East Asia (where the reserve growth has been concentrated), adopt more flexible currency regimes, there will be less official demand for U.S. Treasuries and U.S. dollars. This is critical because central banks, rather than the private sector, are financing the U.S.s account deficit. Or so the argument goes.

A review of some of the trends in foreign currency reserves will help demystify this arcane but important issue.