The idea of the issuance of gold dinar and silver dirham as currency in Kelantan is not new but this week, the northern Malaysian state has decided to go ahead with it finally. This will be a lesson demonstrating the superiority of fiat currency to that which is backed by commodity: commodity-backed currency simply does not do well alongside fiat currency.
Never mind the legality of the whole thing.
First of all, the dinar and the dirham are pegged to the ringgit. This option eliminates the need to use the new currency vis-a-vis the ringgit, notwithstanding the supposedly Islamic ideal. With wider circulation, why would a person not choose the ringgit over the new currency? Call it the status quo bias but that is the reality.
Furthermore, the dinar is likely fail to fulfill the double coincidence of wants, which is necessary for any trade to happen between at least two parties. This is the reason why barter trading is not nearly as popular as trading done through a medium of exchange called money.
A far more threatening factor is the prices of metals. Sufficient increase in gold and silver prices vis-à-vis the exchange rate will make the money more valuable as metals than as a medium of exchange. That will create an incentive to sell the dinar and the dirham as metals, thus lowering the quantity of money in circulation. The next time metal prices go through the roof, one may expect the dinar and the dirham as a currency to collapse or at the very least becoming very, very unpopular. It will be hard to see the currency around and in use.
One possible solution to the circulation problem is that the Kelantan government may want to support the currency by printing more of them. That will prove to be a costly policy to carry out in the long run.
Alternatively, the Kelantan government may reevaluate exchange rate between the commodity-backed currency and the fiat ringgit to address rising gold prices. The higher value of the commodity-backed currency compared to the prices of the relevant metals, the more valuable it will be as currency and less as metals.
If reevaluation is the favored policy, it will be a race between the issuer and arbitrageurs: who can act first. There is an handsome profits to be made. Remember, for instance, the painful experience of the European Exchange Rate Mechanism.
Between a state government (along with the issuer) with no experience in monetary policy and countless arbitrageurs, I have a feeling the state government will not fare too well. I doubt Kelantan has sufficient reserve to support a currency, in case of a run. Somebody once said something to this effect in a different but entirely applicable scenario: the government has to win every time but the arbitrageurs need to win only once to induce a collapse of the currency.
Or, the Kelantan government can float the exchange rate. But if it does so, there is a feeling that that policy would make the dinar redundant as a currency to the ringgit, leading us back to the status quo bias.
 — KOTA BAHARU, Aug 12 (Bernama) — Kelantan paved the way to become the first state to introduce the gold dinar and silver dirham currency on Thursday.
Speaking when launching the Syariah currency, Menteri Besar Kelantan Datuk Nik Abdul Aziz Nik Mat said the state would strive to expand the use of gold dinar and silver dirham in all transactions, including paying civil servants’ remuneration. [Kelantan Launches Dinar Gold. Bernama. August 12 2010]