State-run sovereign wealth funds are diversifying away from the U.S. dollar, as well as dollar denominated assets, at an unheralded pace, as the greenback’s protracted declined undermines the credibility of U.S. policymakers.

The Financial Times reported yesterday (Thursday) that one large, unnamed Gulf fund has cut its dollar-denominated holdings from more than 80% a year ago to less than 60%. Also, China’s State Administration of Foreign Exchange (SAFE) has been actively seeking deals with private equity firms in Europe as part of a specific strategy to reduce its dollar holdings.

A shift in policy at China’s SAFE is particularly significant because it holds the vast majority of China’s $1.6 trillion of foreign currency reserves in dollar-denominated assets. In addition, the FT reported, SAFE is encouraging the private equity firms with which it works to invest in natural resources companies in markets outside of the United States.

With U.S. markets roiled by the subprime meltdown, overseas investors are questioning the credibility of the Federal Reserve and Treasury Department when it comes to defending the dollar and maintaining financial stability.

“I thought the problem of off-balance sheet had gone way with Enron,” the head of one Middle East fund told the FT.

While the shift may seem sudden, Rick Lloyd, head of G10 currency trading at ABN AMRO (OTC ADR: ABNYY) in Singapore, told Reuters that central banks and sovereign wealth funds have been scaling back their exposure to the dollar for some time now.

“That’s something that’s been happening over the course of time, there’s been a supply of dollars on any given rally,” Lloyd said. “The dollar just seems to be getting pushed around in the backwater flows in other markets at the moment.”

Inflation has clearly taken root in the U.S. economy with energy costs leading the way. Worse, continued stress throughout the financial markets, highlighted by difficulties at Fannie Mae and Freddie Mac last week has prohibited the Federal Reserve from raising its benchmark interest rate.

U.S. consumer prices, as measured by the Consumer Price Index (CPI), increased 1.1% in June, bringing the inflation rate for the past 12 months to 5%, well above the U.S. Federal Reserve’s preferred target of 2.0%.

“We have a stagnating economy with rising inflation,” Joel Naroff, president and chief economist of Naroff Economic Advisors said in a note to clients after the CPI report was released. “Clearly, the rate of inflation and the slowdown in economic growth is nothing near what we saw in the 1970s, but the combination of the two is creating real problems for the Federal Reserve.”

The dollar wobbled against the euro yesterday, but the single European currency in late-day trade was at $1.5866 dollars after 1.5821 dollars late Wednesday, the AFP reported.

Source: Sovereign Wealth Funds Reducing Exposure to U.S. Dollar