Central bank holdings of U.S. dollars continue to mount, despite talk of diversification into other currencies, but questions remain about the sustainability of the rise in dollar reserves.

On Friday, the International Monetary Fund said global central banks' hit a new record in reserves held in U.S. dollars at $2.24 trillion in the first quarter, a 4.0 percent increase from the final quarter of 2006.

The greenback's total share of reserves slipped slightly while the euro's share edged up, though the euro's 2.0 percent rise against the dollar in January-March period means valuation gains rather than active diversification accounted for the change.

Overall U.S. dollar holdings in the IMF data, which covers about two-thirds of the world's currency reserves, remained near the 65 percent level that's prevailed over the last three years.

When all is said and done, it appears there's much more said than actually done regarding reductions in dollar holdings, said Marc Chandler, senior currency strategist at Brown Brothers Harriman.

Earlier this week, the European Central Bank said the euro's share in global reserves has remained stable since 2005, suggesting the greenback is still the currency of choice among central banks.

Though they don't report the composition of their reserves, emerging market countries such as China, Russia and the Middle East oil exporters, along with Japan, are thought to be the main dollar holders.

High oil prices bring dollars flooding into the Middle East, while in China's case, intervention to keep the yuan weak keeps export revenues pouring into Beijing's coffers.

As long as those two trends continue, the overall story is one of more central bank demand for dollars, not less, said Brad Setser, an economist at Roubini Global Economics in New York.

CHANGE ON THE HORIZON?

The trend may not last for ever though.

Emma Lawson, currency strategist at Merrill Lynch, said she expects emerging markets such as China, which holds $1.2 trillion in reserves, to let their currencies appreciate as the year goes on in order to stem capital inflows and cool inflation.

That would require the Chinese central bank to buy fewer dollars, which should weigh on the U.S. currency, and force other central banks to actively increase holdings in other currencies over the coming years.

Both the euro and yen would be beneficiaries of such a shift, she said, with the yen's share of global reserves likely to creep back to its historical 6.0 percent level.

The IMF data showed yen holdings stood at just over 3.0 percent of global reserves in the first quarter.

State-run investment funds, designed to take a portion of reserves that usually go to U.S. Treasury bonds and invest them in higher-yielding assets, may also work against the dollar.

We don't see any significant sell-off in the positions foreigners currently have in Treasury and agency debt, we do see the pace of investment beginning to decline, which will prompt a further decline in the U.S. dollar, said Bank of New York strategist Michael Woolfolk.

Indeed, data from the U.S. Treasury showed China in April sold a net $5.8 billion in Treasury bonds, the first drop since October 2005.

But, with $414 billion of Treasuries in its coffers, Chandler called that less than a drop in the bucket.

He added that the sheer size of the U.S. capital markets means dollar-denominated assets will remain a large part of both traditional reserves and the portfolios of yield-hungry state investment firms.

China and Japan have more than $2 trillion of reserves between them, he said. What other market could absorb that kind of money?

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