A vehicle currency is one that provides money characteristics for international transactions. This is usually the reserve currency that handles it.
Like a national currency, a vehicle provides unit of account, medium of exchange, and store of value for public and private international transactions. This helps to reduce the number of exchange rates that have to be dealt with in a multilateral system.
This is following with what occurred historically. Traditionally, there was always a single currency that dominated the world economy in the exchange of goods and assets. For the last 80 years, the US dollar filled this role.
Essentially, institutions engage indirectly with the vehicle currency instead of using direct bilateral trade among their own currencies. The reason for this is to save on exchange rates and to gain greater efficiency in the system.
The main drawback to this is that if there is a problem with the reserve currency, every other currency is affected. One of the biggest keys is the currency be readily available.
The Eurodollar
One of the interesting conversions over the last half century is the move from the US dollar to the Eurodollar. This occurred as a result of the rise of the Eurodollar market. Here we have system that was created by the international banks and financial institutions that was able to replicate the characteristics of the USD while producing many different forms of money.
Here is where we see the availability of the currency enter. One area where the system excelled was by getting money to where it was needed, on a timely basis. This allowed the Federal Reserve to avoid Triffin's Dilemma since the USD could focus upon the US domestic economy and the Eurodollar system could fuel the global economy.
Due to the fact our monetary systems became digital, we saw the financial world turn into a mess of computer networks. This is where the Eurodollar System was born. It came about in the electronic age and converted with technology. The key is that it resides in physical form (banknotes) for only a short period of time, It quickly evolved from a cash basis to simply a ledger.
This is what ended up as the vehicle currency. The Eurodollar was the currency of international banking and finance. Whatever assets used, bonds, derivatives, swaps, they mostly were denominated in USD. This made them useful for not only collateral but also hedging.
When transactions take place internationally, currency itself is rarely used. Instead the institutions utilize some type of dollar denominated asset that is of interest to the other party. Therefore, the total transactions looks something like this:
- $1 million in Krona pulled out of customer's account
- Sending banks sends receiving bank $1 million in USD denominated asset
- Receiving bank put $1 million in Yen in customer's account
It is a system that worked well, until the Eurodollar System broke down.
The Great Financial Crisis
The Eurodollar System took a massive hit during the Great Financial Crisis, something that it never recovered from. This has affected global transactions simply because the vehicle currency is in trouble.
During the period preceding the crisis, we saw a plethora of collateral. This was offered up by both the public and private sector. The former put up sovereign debt, with many countries participating. We saw the private sector putting forth mortgage backed securities (MBS).
It is important to note, that at this time, MBS were rated the same as US Treasuries. This means it was serving as high quality collateral. Unfortunately, as we found out, these were anything but high quality.
After the collapse, once MBS were exposed for what they were, we were left with sovereign debt. This actually returned the system to its traditional levels. However, this would not last too long.
Within 5 years of the collapse, most blew up their bond markets. The put to negative interest rates destroyed the bonds. This removed a great deal of collateral from the equation. What was left was US Treasuries.
This caused a problem simply due to the fact the system ended up starved. With bank balance sheet constrained (even contracting), we had no option but to curtail the lending activity. Where this comes into play is in the short-term lending market which is responsible for funding about 90% of global trade.
The last 15 years saw a tightening of financial conditions globally in spite of the efforts of central banks who undertook historic "money printing" measures. Unfortunately, they were not creating currency since most of the world operates under fractional reserve banking. Hence, the commercial banks expand the money supply via loans. In the United States, as an example, this slowed to a rate of about 1.00% annually since the Great Financial Crisis.
Earlier it was mentioned the key is the vehicle currency to be readily available. With a contraction of bank balance sheets, the entire financial spectrum is feeling the effects of deflationary money. This has resulted in countries being de-dollared as they are finding they cannot put their hand on the assets they need.
All of this leads to an inability to get the vehicle currency. This creates friction throughout the entire economy, resulting in lower global growth.