The dollar milkshake theory is that the state of global currencies is similar to people sitting in a milkshake bar, each drinking the milkshakes in front of them. But one of the milkshake drinkers has a very long straw, and he or she can start drinking from milkshakes at other tables, while the opposite is not true. The person with the long straw can cause all kinds of problems for everybody in the milkshake bar.

In the analogy, the milkshake drinker with the long straw is the dollar, while all the other milkshake slurpers are other currencies around the world. Essentially, the dollar has the capacity to slurp up currencies from all around the world. This is all very graphic, but what exactly does it tell you?

I suppose it tells you this is not a situation you really want. What it doesn’t tell you is why the milkshake drinker would want to drink from those of other patrons, especially since it’s likely to cause a lot of grouchy fellow milkshake drinkers.

Whatever the case, the theory is gaining some traction now because the dollar is extraordinarily strong at the moment. I mean really, really strong. Both the UK pound and the Japanese yen are now at 37-year lows against the dollar. And the consensus is that the pound, at least, is likely to weaken further. It’s currently trading at about $1.14; if it goes below parity, then we are into historic territory.

Almost no country has escaped. The euro is already at parity with the dollar; something that has only happened once in the history of the currency, shortly after its launch in 2002. It almost goes without saying that the rand has been hit too; like the euro and the pound, the rand is down by about 15% over the past year. The incredible thing is that the rand hasn’t fallen faster than the currency of some very big, developed countries. 

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There are two obvious reasons why this is happening. First, in doubtful economic times there is a “flight to safety”. It’s a natural reaction to increased risk. The US economy might not be powering ahead, but compared to most other places in the world, it looks like a safe haven. So investors tend to park their wealth in dollar-denominated assets, just to be safe.

Second, increasing inflation around the world means higher interest rates, and higher interest rates often entail a recalibration of the relative value of debt. Because US interest rates have been climbing faster than, say, those in Europe, if you are getting a -0.08% yield on a two-year bond in Japan, and a 1.545% yield on German Bunds, then it would make sense to sell those and buy a two-year US Treasury at 3.87%.

And this is where the milkshake theory begins to kick in, because it can all turn into a circular, self-fulfilling prophecy. When the US Fed stops printing dollars, then the froth on top of the dollar disappears. Because most of the other countries need the dollar to trade, they start to buy dollars, pushing up its value even further, making dollar-denominated assets even more desirable. And so on.

In normal times, this all tends to balance out over time. You can certainly see many reserve banks around the world, including our own, playing catch-up with the Fed, partly to prevent their own currencies from weakening too much.  But there are more milkshake issues here too, because weaker currencies mean more imported inflation — and that means more sipping from the long straw.

Over the longer term, currency imbalances tend to even out because lower currencies tend to help exporters and hurt importers. So eventually, the imbalance will reflect in trade patterns, and the push-and-pull starts happening in the other direction. And this is where the analogy is a bit weak, because although the slurper with the long straw might want more milkshake, the US doesn’t really want an overvalued dollar. 

But in the meantime, we may have a problem. The rising dollar means dollar-denominated debt burdens can become overwhelming, as we have already seen in Sri Lanka. According to the International Monetary Fund, the debt of about 20 emerging market countries is trading at distressed levels, defined as a yield above 10% on a 10-year bond. SA hit that level in June this year, and that’s higher than it has been in recent history, other than the pre-Covid spurt.

Fortunately, global financial institutions are well aware of the problem. Unfortunately, there is not much they can do about it. And what they can do may be very unpopular. For the emerging world, better-coordinated multilateral debt restructuring will be key.

This has all been done before with the Heavily Indebted Poor Countries (HIPC) initiative in the 2000s. But the problem is that when the HIPC initiative materialised, most of the debt was owed to foreign governments, which were part of something called the Paris Club. Now, most of it is owed to institutions, which are difficult to corral, and even more difficult to induce into forgiving debt. The good news is that quite often this debt is not huge in international terms, so the multilateral institutions can often help.

As the people who frequent milkshake bars often learn the hard way, drinking other people’s milkshakes is unpopular, even when it is satisfying to the drinker. This is something we hope President Cyril Ramaphosa might have raised when he met President Joe Biden at the weekend. DM/BM