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

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 have maintained 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.