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Exchange rate system, policy distortions, and the maintenance of trade dependence

Published online by Cambridge University Press:  22 May 2009

Bruce E. Moon
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Two central tenets of dependency theory are supported by the analysis of the causes and consequences of the exchange rate policies of less developed countries (LDCs). First, one critical component—high partner trade concentrations—is recreated by the choice of exchange arrangements. Specifically, nations that havemaintained a dollar peg have significantly increased their concentration of trade with the United States since 1973. This occurs because of the exchange rate risk present in any transaction that involves a dollar-pegged currency and any other major currency against which it floats. Second, such an effect produces incentives for internal and external actors with an interest in the partner composition of future trade to influence the exchange rate policy of LDCs. Various components of the dependence situation that strengthen the role of such actors—partner trade concentrations, treaty arrangements, foreign aid, etc.—are significantly correlated with actual exchange rate practice. Thus, exchange rate policy is a linch-pin mechanism, in that it both manifests distortions produced by dependency and further acts to recreate a vital aspect of the situation that gave rise to the distortions.

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Articles
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International Organization , Volume 36 , Issue 4 , Autumn 1982 , pp. 715 - 739
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Copyright © The IO Foundation 1982

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References

1 For systematic discussions of dependency theory and related approaches, see Caporaso, James, “Dependence, Dependency, and Power,” International Organization 32, 1 (Winter 1978): 13–43CrossRefGoogle Scholar; Chase-Dunn, Christopher and Rubinson, Richard, “Toward a Structural Perspective on the World System,” Politics and Society 7, 4 (1977): 453–76CrossRefGoogle Scholar; Valenzuela, J. Samuel and Valenzuela, Arturo, “Modernization and Dependency: Alternative Perspectives in the Study of Latin American Underdevelopment,” Comparative Politics 10, 4 (1978): 535–57CrossRefGoogle Scholar.

2 For a variety of treatments of these effects, see Cardoso, Fernando Henrique and Faletto, Enzo, Dependency and Development in Latin America (Berkeley: University of California Press, 1979)Google Scholar; Herring, Ronald, “Structural Determinants of Development Choices: Sri Lanka's Struggle with Dependency,” paper prepared for “The Postwar Economic Development of Sri Lanka” Conference, University of Peradeniya, Sri Lanka, 16–20 12 1980Google Scholar; Frank, André Gunder, “The Development of Underdevelopment,” Monthly Review 18, 4 (1966): 17–31CrossRefGoogle Scholar; Jackson, Steven, Russett, Bruce, Snidal, Duncan, and Sylvan, David, “Conflict and Coercion in Dependent States,” paper prepared for annual meeting of the American Political Science Association, Washington, D.C., 14 09 1977Google Scholar; Sylvan, David, Snidel, Duncan, Russett, Bruce, and Jackson, Steven, “A Formal Model of ‘Dependencia Theory’: Some Empirical Results,” paper prepared for annual meeting of the American Political Science Association, Washington, D.C., 31 08 1979Google Scholar.

3 For a critical indictment of dependency theory on these grounds, see Lall, Sanjaya, “Is ‘Dependence’ a Useful Concept in Analyzing Underdevelopment?” World Development 3, 11–12 (1975): 799–810CrossRefGoogle Scholar. Pleas for patience and a defense of these characteristics are offered by Gould, Lawrence, “Against Trivialization: A Brief Commentary on Dependence, Dependency, and Epistemology,” paper prepared for annual meeting of the Midwest Political Science Association, Chicago, 04 1979Google Scholar; Powell, Sandra and Bills, Terrance, “Dependency Theory: Issues and Prospects,” paper prepared for Latin American Studies Association Meeting, Bloomington, Indiana, 17–19 10 1980Google Scholar.

4 See Heller, H. Robert, “Determinants of Exchange Rate Practices,” Journal of Money, Credit, and Banking 10, 3 (08 1978)CrossRefGoogle Scholar; Dreyer, Jacob, “Determinants of Exchange Rate Regimes for Currencies of Developing Countries: Some Preliminary Results,” World Development 6, 4 (1978): 437–45CrossRefGoogle Scholar; Holden, Paul, Holden, Merle, and Suss, Esther, “The Determinants of Exchange Rate Flexibility: An Empirical Investigation,” Review of Economics and Statistics 61, 3 (08 1979): 327–33CrossRefGoogle Scholar.

5 In practice, many opportunities exist between these two extremes, ranging from the “dirty” or managed float to the “crawling” peg, and including the joint float of the European Monetary System (the “snake in the tunnel”).

6 See Friedman, Milton, “The Case for Flexible Exchange Rates,” in Essays in Positive Economics (Chicago: University of Chicago Press, 1953)Google Scholar; Wallich, Henry, “The Case Against Flexible Exchange Rates,” in MacEwan, Arthur and Weisskopf, Thomas E., eds., Perspectives on the Economic Problem: A Book of Readings in Political Economy (Englewood Cliffs, N.J.: Prentice-Hall, 1970)Google Scholar; Graham, Frank D., “Achilles Heels in Monetary Standards,” American Economic Review 30 (1940), p. 16Google Scholar; Meade, J. E., “The International Monetary Mechanism,” The Three Banks Review no. 63 (09 1964): 3–25Google Scholar.

7 For example, Haberler, Gottfried, “The International Monetary System after Jamaica and Manila” in Contemporary Economic Problems, vol. 2 (Washington, D.C.: American Enterprise Institute, 1977)Google Scholar; Kindleberger, Charles, “Lessons of Floating Exchange Rates,” in Brunner, K. and Meltzer, A., eds., Institutional Arrangements and the Inflation Problem (Amsterdam: North-Holland, 1976)Google Scholar; Peter Kenen, “A Comment on ‘Lessons of Floating Exchange Rates,’“ in Brunner and Meltzer, Institutional Arrangements and the Inflation Problem; Tower, Edward and Willett, Thomas, The Theory of Optimum Currency Areas and Exchange-Rate Flexibility, special papers in International Economics no. 11 (Princeton, N. J., 1976)Google Scholar; Artus, Jacques and Young, John, “Fixed and Flexible Exchange Rates: A Renewal of the Debate,” IMF Staff Papers 23 (07 1979): 312–33CrossRefGoogle Scholar.

8 For the general argument, see Tower and Willett, Theory of Optimum Currency Areas, and Artus and Young, “Fixed and Flexible Exchange Rates.” The source of exchange rate volatility in the post-1973 period is the center of a controversy pursued most vigorously in the “efficient markets” literature. See Frenkel, Jacob and Mussa, Michael, “Efficiency of Foreign Exchange Markets and Measures of Turbulence,” American Economic Review 70, 2 (1980): 374–81Google Scholar for a guide. The quite thin capital and foreign exchange markets of LDCs make it more likely that volatility is a consequence of market factors and not real economic forces. Cyclical fluctuation is also commonplace among LDCs.

9 See Mills, Terry and Wood, Geoffrey, “Money-Income Relationships and the Exchange Rate Regime,” Economic Review [of the Federal Reserve Bank of St. Louis, Mo.] (08 1978)Google Scholar.

10 Heller, “Determinants of Exchange Rate Practices.” For a more thorough theoretical treatment, see the excellent survey of Black, Stanley, “Exchange Policies for Less Developed Countries in a World of Floating Rates,” Princeton Essays in International Finance no. 119 (Princeton, N.J., 12 1976)Google Scholar. Also see Lipschitz, Leslie, “Exchange Rate Policy for a Small Developing Country and the Selection of an Appropriate Standard,” IMF Staff Papers 26, 3 (09 1979): 423–49CrossRefGoogle Scholar; Crockett, Andrew and Nsouli, Saleh, “Exchange Rate Policies for Developing Countries,” Journal of Development Studies 13, 2 (01 1977): 125–43CrossRefGoogle Scholar.

11 For a simple explication, see Caves, Richard E. and Jones, Ronald W., World Trade and Payments: An Introduction (Boston: Little, Brown, 1973)Google Scholar, Part 4.

12 See the classic formulations of Mundell, Robert A., “A Theory of Optimum Currency Areas,” American Economic Review 51 (09 1961)Google Scholar; and McKinnon, R. I., “Optimum Currency Areas,” American Economic Review 53 (09 1963)Google Scholar.

13 Real, nominal, and effective exchange rates are discussed below and in Helleiner, G. K., “The Impact of the Exchange Rate System on the Developing Countries: A Report to the Group of Twenty-four,” UNDP/UNCTAD Project INT/75/015 (1981)Google Scholar.

14 Moreover, counterarguments for most of these rules can be found. For example, the argument that small, open, undiversified economies may benefit from a float has been advanced by Kenen, Peter, “The Theory of Optimum Currency Areas: An Eclectic View,” in Mundell, R. and Swoboda, A., eds., Monetary Problems of the International Economy (Chicago: University of Chicago Press, 1969)Google Scholar; and Whitman, Marina, “Economic Openness and International Financial Flows,” Journal of Money, Credit and Banking 1 (11 1969)CrossRefGoogle Scholar. This remains a minority view but it is plausible that under some circumstances exchange rate changes are preferable to the other forms of adjustment that would be required to sustain a peg. Of course, the various macroeconomic consequences of the various types of perturbations are complex. Given certain assumptions about the sources of the perturbations (such as weather altering export supply or worldwide economic cycles affecting export demand) and certain priorities (such as giving primacy to holding down inflation or protecting the poorest of the poor), a preferred exchange regime can often be prescribed. In the general case, however, Heller's judgments are certainly not unambiguously true.

15 Heller, H. Robert, “Choosing an Exchange Rate System,” in Adams, John, ed., The Contemporary International Economy: A Reader (New York: St. Martin's Press, 1979), p. 264Google Scholar.

16 Neither Heller's data nor mine were sufficient to investigate the mainline explanation of the choice of reference standard, which involves the stability of real—as opposed to nominal—exchange rates and the maintenance of purchasing power parity (PPP) among the trading countries. For an example of PPP, see Lipschitz, “Exchange Rate Policy.” In general, this explanation asserts that nations can minimize fluctuations in real exchange rates by paying close attention to such trends as differential changes in price levels of traded goods—roughly, inflation rates—and pegging to a nation with a similar profile of conditions relevant to purchasing power parity. A peg likely to minimize fluctuation in effective exchange rate is the currency of a leading trade partner. The difficulty in computing the optimum basket according to these criteria is illustrated by Lipschitz, Leslie and Sundararajan, V., “The Optional Basket in a World of Generalized Floating,” IMF Staff Papers 27, 1 (03 1980)Google Scholar. It remains an open question whether nations are capable of such analysis. As we see below, there is strong evidence that such elaborate calculations are not required to account for actual policy choice.

17 Heller, , “Choosing an Exchange Rate System,” p. 264Google Scholar.

18 The case of the Volkswagen “Beetle“ in American markets is an interesting illustration. The decision of Volkswagen to produce the Beetle for the American market involved a very expensive commitment of resources, most of them long-term. The decision was based upon presumed future demand conditions in the United States, namely that the Beetle would be price-competitive with cheaper lines of American cars for the foreseeable future. Unanticipated was the major devaluation of the dollar relative to the Deutsche mark that occurred from 1973 to 1975. The result was that the dollar price of the Volkswagen soared even in the absence of any change in production cost. The competitive edge relative to American cars disappeared and Volkswagen incurred the first annual loss in its history. Shortly thereafter Volkswagen altered production to emphasize a line of automobiles that derived its competitive position from its inherent quality (such as fuel efficiency) rather than its price, which was subject to unpredictable fluctuation. In addition, American consumers who purchased the Beetle found that prices of spare parts, etc., no longer reflected conditions at times of purchase. All in all, participants in these kinds of transactions are often dismayed by the unanticipated effects of currency fluctuation.

19 Of course, it may well be that exchange rate changes favor the investor, but it remains the case that exchange risk discourages the transaction since not all bond investors wish to engage in the currency speculation inherent in such a purchase. Hedging in the currency markets is also possible but ordinarily it carries resources costs, which must also operate to discourage the transaction itself. Such hedging is far more difficult for LDCs, and often all but impossible. Most LDC currencies, for example, have no forward market.

20 This disincentive applies only to fluctuations of effective real exchange rates. Of course, should nominal rate changes exactly offset changes in price levels within a given sector, no such effect would occur. Most often, however, nominal rate changes have not moved, particularly in the short-run, so as to maintain PPP. For the evidence, see Genberg, Hans, “Purchasing Power Parity under Fixed and Flexible Exchange Rates,” Journal of International Economics 8 (1978): 247–76CrossRefGoogle Scholar, and Krugman, Paul, “Purchasing Power Parity and Exchange Rates: Another Look at the Evidence,” Journal of International Economics 8 (1978): 397–407CrossRefGoogle Scholar. Moreover, it is clear that fluctuations in real rates are significantly greater than those of nominal rates. See Helleiner, “Impact of Exchange Rate System.”

21 For the contrary view, see Friedman, “Case for Flexible Exchange Rates.”

22 Hooper, P. and Kohlhagen, S., “The Effects of Exchange Rate Uncertainty on the Prices and Volumes of International Trade,” Journal of International Economics (11 1978)Google Scholar.

23 Abrams, Richard K., “International Trade Flows under Flexible Exchange Rates,” Economic Review [of the Federal Reserve Bank of Kansas City] (03 1980)Google Scholar.

24 The Abrams estimate is on the high side in comparison with similar studies surveyed in Artus and Young, “Fixed and Flexible Exchange Rates.” Most have concluded there is little or no effect empirically discernable. It is generally believed, however, that such effects are markedly greater among LDCs. For evidence, see the specific country analyses cited in Helleiner, , “Impact of Exchange Rate System,” p. 101Google Scholar.

25 The most frequently used baskets are the SDR and a basket weighted according to the partner shares of the nation's current imports or exports. In both cases, bias toward a single partner is avoided. Officially the value of the SDR is set as the sum of values of: 54 U.S. cents (1/100 U.S. dollar); 46 German pfennigs (1/100 German Deutsche mark); 34 Japanese yen; 74 French centimes (1/100 French franc); and 7.1 British pennies (1/100 British pound). At exchange rates of 12 February 1981, this gave the SDR a value of U.S. $1.25 and the following proportions: Dollar $.54 (43%); Mark $.22 (18%); Pound $.17 (13%); Yen $.17 (13%); and Franc $.15 (12%); totaling $1.25 (100%).

26 According to the IMF, these categories can be “a misleading guide as to the actual policy being followed.” This is so because pegs can be frequently adjusted while floats can be heavily managed. See International Monetary Fund, Annual Report (Washington, D.C., 1976)Google Scholar; Holden, Holden, and Suss, “Determinants of Exchange Rate Flexibility.”

27 For a description of the actual SPSS program used, see Nie, Norman et al. , Statistical Package for the Social Sciences, 2d ed. (New York: McGraw Hill, 1975)Google Scholar.

28 This same argument applies, of course, to other transactions as well, including such capital flows as the economic loans utilized as an indicator in Hypothesis 3 below.

29 For example, see Richardson, Neil R., Foreign Policy and Economic Dependence (Austin: University of Texas Press, 1978)Google Scholar; Richardson, Neil R. and Kegley, Charles, “Trade Dependence and Foreign Policy Compliance,” International Studies Quarterly 24, 2 (1980): 191–222CrossRefGoogle Scholar; Mahler, Vincent, Dependency Approaches to International Political Economy: A Cross-National Study (New York: Columbia University Press, 1980)Google Scholar.

30 Because of the centrality of OPEC in recent monetary affairs and the size of the petroleum trade in relation to changes in partner concentrations during this time period, OPEC membership was included as another potentially important national attribute variable. It was not significant as a dummy variable in this or any other of the discriminant analyses reported below. Indeed, all the analyses in this paper, including the regression, were rerun with OPEC as a dummy variable and with OPEC nations excluded. In no case were the differences even marginally significant.

31 An analysis seeking to discriminate only between dollar peggers and floaters was conducted to check that these results were not a consequence of lumping together dollar peggers—for whom high American import shares would be expected—with other peggers—for whom much lower levels would be anticipated. The results were even more unambiguous: the firstorder choice between floating and pegging is not significantly affected by American import shares.

32 One possible explanation concerns systematic error in the arms transfer data. Kolodziej, (“Measuring French Arms Transfers,” Journal of Conflict Resolution 23, 2 [06 1977])Google Scholar reports significant understatement of French arms data, thus presumably considerable overestimating of American arms concentration for those nations which receive arms from both. I am grateful to Philip Schrodt for calling my attention to this possibility.

33 For a guide to the literature on dependency reversal, see Orton, Keith and Modelski, George, “Dependency Reversal: National Attributes and Systemic Processes,” paper presented to the Annual Meeting of the International Studies Association, Toronto, 21–24 03 1979Google Scholar.

34 For a codification of world system views on this relationship, see Chase-Dunn and Rubinson, “Toward a Structural Perspective.”

33 Most prominent—and explicable—among these floaters is Switzerland, but the list also includes Spain and Iceland.

36 Thygesen, Neils, “Exchange Rate Experiences and Policies of Small Countries: Some European Examples of the 1970s,” Princeton Essays in International Finance no. 136 (Princeton, N.J., 12 1979)Google Scholar.

37 See Helleiner, “Impact of Exchange Rate System,” for evidence that in some respects a basket peg would be preferable even for partner trade concentrated nations.

38 Thygesen attributes shifts of Sweden and Norway into and out of the snake to periodic concern about the need for such external support; see “Exchange Rate Experiences.”