UPDATE 2-Watanabe: Japan won't diversify dollar reserves now

(Recasts and updates with fresh comments, includes background)

NEW YORK, June 19 (Reuters) - Japan would diversify its huge stash of dollar reserves only if the U.S. currency stabilizes, as a premature move could roil financial markets, the country's vice finance minister for international affairs said on Tuesday.

Hiroshi Watanabe, Japan's top financial diplomat, said that for now the world's second-largest economy has no immediate plans to switch the dollars in its reserves for another currency.

"Japan has absolutely no intention of diversifying away from U.S. dollars. In the future, we may do so but only when the dollar is solid and stable," Watanabe told a group of reporters after a speech in New York.

"To diversify right now would have a huge negative impact on financial markets because of the size of our reserves."

Central bank accumulation of dollars in the last several years has played a large part in keeping U.S. bonds yields low because the dollars are often recycled into ultra-safe U.S. Treasury debt.

Japan has the world's largest holding of tradable U.S. Treasuries, worth about $615 billion.

However, the dollar's decline since 2001 has sparked ongoing worries among investors and analysts that Asian governments and oil-exporting countries that collectively own more than half of all official holdings of U.S. Treasuries could switch out of dollars.

Adding some fuel to those concerns, the share of dollars in central bank reserves fell to the lowest in a decade in the fourth quarter of 2006, according to the International Monetary Fund.

CARRY TRADES

One of the other by-products of the tremendous buildup in dollar reserves has been very low market volatility. Such an environment has fueled interest in yen carry trades, in which investors borrow cheaply in yen to buy other higher-yielding assets.

Watanabe downplayed the significance of the size of the yen carry trade but said that central banks should closely watch the impact of the popular strategy.

"There is a need to monitor the 'narrow' type of carry trades," he said. "These are purely for speculation," adding that estimates of the size of the yen carry trade at $1 trillion were hugely inflated.

Carry trades did not pose a threat to the Japanese economy, Watanabe said.

Speculators, driven by carry trades, have helped to push the euro to record highs against the yen above 166 yen. The dollar has risen to the highest in 4-1/2 years against the yen as well.

Watanabe said it was difficult to see a hasty unwinding of Japanese households' huge investments overseas. Japanese retail investors, faced with the lowest interest rates in the industrialized world at home, have been pouring money offshore in search of better returns.