Dollar denominated debt, Dollar Milkshake theory and Japanese Yen Crisis

“In God We Trust; all others must pay in U.S. dollars.”

Pop Quiz — If Country A wants to buy anything Country B is selling, it could be oil, wheat, toilet paper or electronics, how will Country A pay for it? Will he use his own currency or Country B’s currency or US dollar?

Answer — “
Ah, the age-old question of how nations settle their shopping bills on the global marketplace. Here’s the deal: When Country A wants to pick up anything from Country B’s shelf — be it oil, wheat, or the latest electronic gadget — the currency they use to swipe for these goods isn’t just a matter of national pride but of practicality and economic strategy.

Typically, the transaction doesn’t require any complicated currency gymnastics. More often than not, they’ll just use the U.S. dollar, the world’s favorite financial linchpin. It’s like everyone at the party agreeing to split the bill using only one person’s credit card because it’s just easier that way. The dollar is that friend with the platinum card.

Why the U.S. dollar, you ask? Well, it’s because the dollar acts as a global economic adhesive — it’s widely accepted, stable, and as liquid as your morning smoothie. So, whether it’s oil from Country B or Country A needing a new batch of electronics, the dollar often ends up being the go-to currency, even if it feels like bringing a third wheel on a private date.

Of course, they could use Country A’s or Country B’s currency if they’re feeling adventurous and want to test the waters of foreign exchange risks and bilateral agreements. But why complicate things? It’s like deciding to pay for your tacos in yen at a food truck in Texas. Technically possible, but expect some raised eyebrows and a lot of calculator tapping.”

What is dollar-denominated debt?

“If you think nobody cares about you, try missing a couple of payments. Especially those in dollars.”

Dollar-denominated debt refers to loans or bonds issued outside of the United States but which require repayment in U.S. dollars. It’s like deciding to pay for your French croissants using American dollars — convenient for you if you earn in dollars, but it can get tricky for the baker if the euro dances away from the dollar’s tune.

This financial mechanism is popular primarily because the dollar holds the stage as a global heavyweight. Over 60% of all international reserves are held in dollars, and it dominates international transactions — making it the currency of choice for many global dealings​ (Home)​. This widespread use is what economists lovingly call a ‘network externality’: the more people use it, the more useful it becomes.

However, for countries that don’t earn in dollars, this can lead to a scenario where they’re essentially taking a gamble on the dollar’s exchange rate. If their own currency depreciates against the dollar, their debts suddenly become more expensive to service, like ordering a cocktail priced in euros with a wallet full of depreciating dollars.

The allure of lower rates on dollar debts can be tempting. It’s often cheaper to borrow dollars than local currency due to the high demand and perceived stability of the dollar, making these loans like a financial siren song for countries looking to fund development without immediate large capital​ (Harvard Kennedy School)​.

Yet, in the stormy seas of global economics, the dollar’s dominance is both a safe harbor and a potential maelstrom. When the U.S. Federal Reserve tweaks its interest rates, it can send shockwaves far beyond American shores, impacting countries that have borrowed heavily in dollars. They might find themselves strapped for cash when the dollar’s value spikes​ (Brookings)​.

Pop Quiz — If you are outside USA and have 1 Million US dollar equivalent of cash in any currency what will you do? Buy Apple share or US real estate or Vanguard high yield ETF or invest in local real estate or stock market or FD?

When contemplating an investment strategy with $1 million US dollar equivalent outside the USA, opting for U.S.-denominated assets like Apple shares, U.S. real estate, or a Vanguard high-yield ETF presents a compelling case for several reasons rooted in macroeconomic stability and global financial dynamics.

Firstly, investing in U.S. assets such as Apple shares or a diversified ETF offers exposure to the world’s largest economy and a market known for its robust regulatory framework, transparency, and innovation. These investments provide potential growth and stability that might outpace many local alternatives, especially in volatile economic environments.

U.S. real estate also offers a tangible asset that benefits from the general economic stability and property rights enshrined in the U.S. system. Real estate in key markets can provide both appreciation and income through rentals, while also serving as a hedge against inflation.

Investing in U.S. assets like these generally assumes a lower risk profile compared to local real estate or stock markets, especially in countries with unstable currencies or economies. The U.S. dollar itself is a global reserve currency, favored for its liquidity and perceived safety. Holding investments in dollars can protect against local currency devaluation.

What is dollar milkshake theory?

The Dollar Milkshake Theory, quite a creative nomenclature by Brent Johnson, conjures an image of global economics that might remind one of a strange diner experience. Here’s a simple breakdown served with a side of wry humor, befitting a sophisticated taste:

1. Worldwide Milkshake Party: Think of the world’s economy as a giant milkshake with various countries contributing their own flavored currencies. The U.S. dollar, however, isn’t just another flavor; it’s the straw.
2. The Great Suck: Amidst economic turbulence, as central banks around the world try to manage their local crises, the U.S. slurps up capital because its policies tend to attract more liquidity. This means in times of global financial stress, money flows towards the dollar due to its perceived stability and potential for higher returns.
3. Liquidity and the Long Straw: Central to this theory is the idea of a global liquidity squeeze. When the world is thirsty for cash, the U.S. has a way of offering a tall, cold glass of dollar — that is, it can provide liquidity when and where it’s needed, sucking up capital from the rest of the world.
4. Quantitative Easing on Steroids: The U.S. Federal Reserve has a penchant for what’s known as Quantitative Easing (QE) — buying up securities to inject money into the economy. This action not only expands the U.S. money supply but also tends to keep the dollar strong against other currencies, which keeps the capital flowing stateside.
5. The Side Effects: As the dollar strengthens, other currencies weaken, making it harder for countries to repay dollar-denominated debts. This can lead to economic strain globally, especially in emerging markets that may then face financial instability and challenges in maintaining economic growth.
6. U.S. Interest Rates as a Magnet: Higher relative interest rates in the U.S. attract investors looking for the best bang for their buck. As they buy up dollar assets, they contribute to the dollar’s strength, continuing the cycle of capital inflow to the U.S.
7. Consequences of a Bulked-up Dollar: A stronger dollar isn’t all milk and honey. It can make U.S. exports more expensive and imports cheaper, potentially leading to trade imbalances. Plus, multinational corporations face a conundrum; while their purchasing power increases, the value of foreign revenue in dollar terms decreases.
8. Global Geopolitical Milkshakes: A dominant dollar reinforces the U.S.’s influence over global finance, affecting geopolitical dynamics and economic policies worldwide.
9. Emerging Market Vulnerabilities: These markets often rely heavily on foreign currency borrowing. A strengthening dollar increases their debt burden, potentially leading to economic downturns within those nations.
10. Crypto on the Side?: Interestingly, the theory touches on cryptocurrency too. In a world where the dollar dominates, cryptos might become a refuge for those looking to hedge against a strong dollar. However, this sector is also fraught with volatility and regulatory uncertainties.

How Dollar Milkshake theory explains current Japanese Yen crises?

The current crisis with the Japanese yen can be directly linked to the Dollar Milkshake Theory, which Brent Johnson proposed to explain the dominant role of the US dollar in the global economy amidst financial turbulence. Here’s a distilled version of how this theory plays out, particularly in Japan’s situation:

1. Global Liquidity Squeeze: The Dollar Milkshake Theory posits that during global financial stress, capital tends to flow towards the US dollar due to its perceived stability and liquidity. This flow is exacerbated by a global shortage of easily accessible funds, which enhances the dollar’s appeal as other currencies falter​ (CoinWire)​.
2. Dollar Funding Shortage and Repatriation: As crises unfold, there is typically a scramble for dollar liquidity, which means that global markets, including Japan, may find themselves in a shortage of dollars. This shortage drives up the value of the dollar relative to other currencies, including the yen. Additionally, there’s a trend of repatriation where investors pull back investments to their home country, in this case, the U.S., thus strengthening the dollar even more at the expense of other currencies​ (CoinWire)​.
3. Quantitative Easing in the U.S.: The U.S. Federal Reserve has been adept at implementing quantitative easing, buying up securities to inject liquidity into the market. This policy not only bolsters the dollar but also makes U.S. assets more attractive, pulling even more capital away from other markets, like Japan, exacerbating the yen’s weakness​ (CoinWire)​.
4. Interest Rates and Economic Policies: The U.S. has managed to maintain relatively higher interest rates compared to Japan, which has kept its rates extremely low to manage its high debt-to-GDP ratio. This discrepancy makes dollar-denominated assets yield higher returns, attracting more global capital into the U.S. and away from Japan, further pressuring the yen​ (DataWallet)​.
5. Market Dynamics and Currency Flows: As the dollar appreciates due to these combined factors, other currencies depreciate. This dynamic causes a cycle where the depreciation itself triggers further capital flight from weakening currencies (like the yen) to the strengthening dollar​ (CoinWire)​.

In essence, the Dollar Milkshake Theory encapsulates how U.S. financial policies, especially around liquidity and interest rates, create a scenario where the dollar ‘sucks in’ global capital, leaving other currencies, notably the yen, to face depreciative pressures. This theoretical framework helps explain why Japan’s yen is particularly vulnerable in the current economic climate, as global investors flock to the safety and higher returns of dollar-denominated assets, leading to a kind of financial exodus from the yen.

Why Japan has to keep its rates extremely low to manage its high debt-to-GDP ratio?

Japan’s economic strategy of maintaining ultra-low interest rates, despite a towering debt-to-GDP ratio, can be likened to someone treading water while wearing a backpack full of rocks. Imagine Japan is a person, and their debt is a backpack filled with 263% of their weight in rocks — it’s heavy, but they’re somehow still afloat. Here’s why they can’t just dump the rocks:

1. Interest Rate Limbo: Keeping interest rates low is Japan’s way of making sure the interest on their massive debt doesn’t skyrocket. If rates went up even a bit, the cost of their debt would turn from a manageable annoyance into an overwhelming burden — kind of like turning up the gravity while our hypothetical swimmer is already struggling to keep their nose above water​ (Liberty Street Economics)​​ (Wikipedia)​.
2. Growth Stagnation: Japan’s economy isn’t exactly sprinting; it’s more like an elderly walk. With economic growth barely making any progress, raising interest rates could push the economy from slow-motion to full stop. It’s a delicate balance, where even a small misstep could lead to a bigger economic stumble​ (Liberty Street Economics)​​ (Wikipedia)​.
3. Aging Population: This is where it gets even trickier. Japan has more retirees than most countries, which means more pensions and healthcare costs and fewer workers to bear the load. Raising interest rates could help save money on pensions but at the risk of making life more expensive for everyone else​ (Liberty Street Economics)​.
4. Asset Leveraging: Interestingly, Japan does have a hefty portfolio of assets, which helps offset some of the debt. It’s like having a few floatation devices thrown into the backpack. These assets include investments and foreign currency reserves that provide some financial leeway​ (Liberty Street Economics)​.

So, why keep rates low? It’s all about survival. Raising rates might initially seem like a good idea to attract investment and strengthen the yen, but it could backfire by increasing debt costs, slowing economic growth, and making life tougher for an already aging population. It’s a complex, delicate dance of economic priorities, where the wrong move could sink the swimmer​ (Liberty Street Economics)​​ (Wikipedia)​.