Box 2.4 Zimbabwe’s attempts to control the real exchange rate

institutional mix in Southern Europe needs strengthening to improve resilience before the inevitable next crisis hits. Weak institutions, weak resilience and low trust create a vicious, “scarring” circle, emphasizing the urgency to redouble the reform efforts going forward. Fortunately, Portugal has made substantial institutional improvements since the crises, while trust in institutions is in the “green”. Others have made progress on some key policy variables (e.g. active labor market policies in Spain, better product market regulation in Italy). Reform is particularly urgent for Spain and Greece, as their citizens’ trust in formal institutions is among the lowest in the EU.

Does a flexible exchange rate compensate for a weak policy mix? For instance, Poland’s resilience is quite strong, on par with the Netherlands and Denmark, but with weaker institutions. Romania and Bulgaria also record relatively strong resilience, but with institutions that tend toward the “red” zone. And a traditional optimal currency area indicator—business cycle synchronicity—would not have predicted the relative strength of Poland’s and Romania’s resilience in the face of the crises of the last decades. A plausible hypothesis would be that the flexible nominal exchange rate compensates for the weaker policy mix. This could also explain the relatively positive outcome performance of Romania, a floater with a weak policy mix, vis-à-vis for instance Slovenia, a newer EU and eurozone member with relatively strong institutions and business cycle synchronicity with the eurozone core, but weak resilience.

The results describe the euro area experience during the last decade: if an economy cannot use the nominal exchange rate as a shock absorber and its monetary policy to temper booms and counter-act busts, the flexibility of the real exchange rate takes center stage. This implies strengthening the institutions that assist in absorbing a shock and facilitating a strong rebound. Boosting resilience across the EU would be based on a policy mix that reduces income inequality, protects low incomes, creates flexibility in labor markets (supported by collective bargaining and active labor market policies), supports private sector competition (while ensuring the ease of doing business) and strengthens trust in institutions. In the following sections, we investigate in more detail the policy and institutional setting that is associated with the resilience patterns described above and shown in the heatmap.

The more the economies of a monetary union are in sync, the more effective a common one-size-fits-all monetary policy and exchange rate policy will be in fostering resilience. This is why business cycle synchronicity has always been considered a core criterion for an optimal currency area. The more synchronicity, the more a common monetary policy will be effective in achieving its stabilization task. Conversely, the less synchronicity, the more the real exchange rate will need to absorb the shock. Annex 7 provides the details of the analysis.

This report finds no completely consistent association between business cycle synchronicity and resilience. Countries were ranked according to the correlation of their cyclical output gaps: the darker the color, the stronger the correlations (Figure 2.3). The correlation with resilience is positive, but with notable exceptions. First, while Poland is strongly resilient, its business cycle synchronicity is much weaker. It shares this pattern with Romania. Other Central and Southeastern European countries show relatively more synchronicity, but less resilience: Czechia, Bulgaria, Croatia and Hungary. Italy and Slovenia are highly synchronized with Europe’s core, but less resilient. Except for Italy, Southern Europe is poorly synchronized with the eurozone’s core. Business cycle synchronicity is strongest among the “core” EU countries: Germany, France and Austria.