Before discussing the above topic, I think it is important to distinguish between a fiat currency and a commodity currency.

Fiat Currency

Let’s first explain what the word “fiat” means (and no, it’s not an Italian car and it is not an acronym for “Fix It Again Tomorrow”). Fiat is a Latin word meaning “be done“. Now that we explained the literal meaning of the word, let’s examine what a fiat currency is. A fiat currency is money which value is guaranteed by the issuing government. Every currency in the world is a Fiat currency, because if it’s not backed by the issuing government, then it completely loses its value.

Commodity Currency

A commodity currency is a currency which value goes up and down with respect to the USD or a basket of other currencies proportionally with the price of the commodities that are produced and exported by the issuing country (for example, oil, cocoa, natural gas, wheat, corn, etc…). According to the IMF, the relationship between the commodity price and the commodity currency is 10 to 3.8, so a 10% increase in the commodity price will result in 3.8% increase in the currency price. Let’s say, for example, that we have a country producing and exporting both oil and gold (Hmmm, I wonder if I’m talking about Canada), and the price of both combined went up 5%, this means that its currency should go up 1.9% (according to the above ration of 10:3.8) with respect to the USD (which is the purest of the purest fiat currencies).

Now that we explained what both types of currencies are, let’s answer the question. Is the loonie a fiat or a commodity currency? Well, according to the explanation above of a fiat currency, any currency in the world, including the Canadian dollar, is a fiat currency. Imagine that the Canadian dollar decided at one point to stop issuing and accepting Canadian dollars and use the USD instead, what will happen to its value? Who will accept the Canadian dollar for any payment if this happens? No one for sure.

So we’ve established that the Canadian dollar is a fiat currency, but can it also be a commodity currency. According to the IMF, countries with commodity currencies are:

• Central African Republic
• Australia
• Bangladesh
• Bolivia
• Ivory Coast
• Ecuador
• Ghana
• Iceland
• Indonesia
• Kenya
• Malawi
• Mali
• Mauritania
• Morocco
• Niger
• Papua New Guinea
• Paraguay
• Syrian Arab Republic
• Togo

We can easily notice 2 things by taking a glimpse at the above list:

– Canada is not one of them
– Most of these countries have very weak and poor economies

The thing is, when defining the commodity currency above, I have explicitly omitted that for a currency to quality as a commodity currency, the issuing country’s economy must be heavily dependent on the exports of its main commodities.

In the case of Canada, here’s how each sector’s contribution to the economy is broken down (according to the CIA factbook – 2010 estimates):

• Agriculture: 2%
• Industry: 20%
• services: 78%

The thing is that, in the real world, the oil’s and gold’s exports contribution to the Canadian economy are minimal. Which essentially makes the Canadian currency an non-commodity currency. But, why is it that the loonie proportionally moves with the price of oil and gold? I guess there’s only one answer to this question, “Ask the speculators”.

After writing this article, I have come to realize that the loonie is highly overpriced because it’s heavily relying on the price of the main commodities (which contribution to the country’s economy is minimal), while giving little consideration to the factor that has the biggest impact on the Canadian economy, the US economy!

I believe that when all the dust settles (oil, gold, US economy, etc…), the loonie will regain its real value, which is much lower than what it really is. Not to mention, of course, that a lower loonie provides a huge advantage to the Canadian economy, which exports and services are becoming more and more unaffordable.