Commodity currency

A commodity currency is a name given to some currencies that co-move with the world prices of primary commodity products, due to these countries' heavy dependency on the export of certain raw materials for income.[1]

Commodity currencies are most popular in developing countries (eg. Burundi, Tanzania, Papua New Guinea). However developed countries like Canada and Australia can also have this type of currency. For example, the Canadian Dollar grows stronger, the higher the price of soybeans and oil because these are Canada's two major commodities.[2]

In the foreign exchange market, commodity currencies generally refer to the Australian dollar, Canadian dollar, New Zealand dollar, Norwegian krone, South African rand, Brazilian real, Russian ruble and the Chilean peso.

Effects

Due to the nature of commodity currencies being tied to commodities, being tied to any one good can be beneficial as well as problematic for the country. While naturally, falling or rising exports will lead to deflation or inflation respectively in any country the impacts are more severe in countries with commodity currencies at their currency is so heavily tied to a set few commodities.

Positive

According to a 2009 study on commodity currency titled “Can Exchange Rates Forecast Commodity Prices?” by Yu-chin Chen, Kenneth Rogoff and Barbara Rossi, exchange rates of commodity currencies can predict future global commodity prices. This is hugely beneficial for economists and policymakers who want a reliable measure of future commodity prices.[1]

A currency that is naturally tied to a country’s major commodities can be beneficial if the global demand for a commodity increases, naturally strengthening the value of the currency. As seen in Figure 1 as the demand for a commodity shifts out (higher demand) the price increases to p’. This increased demand also is likely to increase GDP as more exports take place as demonstrated by the equation for GDP below.

Figure 1
Figure 2

As exports increase due to the higher demand, GDP will also increase greatly as this country relies heavily on this commodity leading to higher prices causing inflation (indicated in Figure 2’s increase in the price level). Depending whether the country needed inflation or not this could be positive as noted in the positive effects section of the inflation article.

It is important to note that while countries with commodity currencies benefit from the higher demand, countries that import this commodity face the opposite effects.

Negative

On the other side, a currency being tied to the major commodities of a country can be problematic as a decrease in demand for any specific commodity can take a huge toll on the countries currency leading to deflation.

As seen in Figure 3 as the demand for a commodity shifts out (more demand) the quantity decreases to p’. This increased demand also is likely to decrease GDP as more exports take place as demonstrated by the equation for GDP below.

Figure 3
Figure 4

Similar to the reasoning in the previous section, as seen in Figure 4, a decrease in the GDP leads to deflation. This can have negative or positive effects depending on whether the currency was overvalued or not, deflation can either be positive or negative in the long run as suggested by the effects section of the deflation article.

It is important to note that while countries with commodity currencies benefit from the higher demand, countries that import this commodity face the opposite effects.

Investing

Commodity currencies nature can allow foreign exchange traders to better gauge the value of a currency and predict the movements within the markets based on the perceived value of the commodity to which the currency is tied. Knowing which currencies are tied to which commodities can assist greatly with trading decisions.

All in all, If looking to trade commodity currencies it is extremely important to closely follow the movements of the commodities to which they are tied and short or long a currency accordingly.[3]

Externalities

Most commodities that are tied to currencies are natural resources such as gold, oil timber and other minerals.[1] However the mining of these raw resources can lead to immense externalities such as pollution. Countries that do not have their currency informally tied to a commodity will naturally have an easier time cutting down on these harmful processes reducing their affiliated externalities.

Countries with commodity currencies have difficulty changing their behaviors and reducing externalities with respect to the commodities that have a profound impact on their currencies. For example, the Canadian dollar is closely tied to soybeans and oil. The production of oil is extremely harmful to the environment however reducing its production through Cap and Trade programs or production taxes can be devastating to the Canadian Dollar.

See also

References

  1. 1 2 3 Chen, Yu-Chin; Rogoff, Kenneth; Rossi, Barbara (2010). "Can Exchange Rates Forecast Commodity Prices?". Quarterly Journal of Economics. 125 (3): 1145–1194. doi:10.1162/qjec.2010.125.3.1145.
  2. ↑ "Commodity Currency". TheFreeDictionary.com. Retrieved 2018-03-06.
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