Analysis of the money supply trend

A pick-up in money supply growth has been visible since the beginning of 1999. The year-on-year growth rate rose from approximately 5% at the end of 1998 to around 10% at the end of May. The question arises as to what, in a situation of ongoing low credit supply by banks, is causing the rise in these year-on-year increases in M2.

In keeping with the present exchange rate regime, where the central bank makes virtually no foreign exchange interventions, the money supply was affected up to the end of 1998 mainly by bank lending to businesses and households. The external sector played no major role in the money supply. The equal rate of year-on-year growth in credit supply and M2 up to the end of 1998 is evident from the following chart.

Evolution of Money Supply and Credit Issue of Banks
Chart: Evolution of Money Supply and Credit Issue of Banks

Since the beginning of this year, the growth rates of these two indicators have differed substantially. In this period, the money supply has been affected by another factor, namely the trend in net foreign assets, which during the first five months this year rose by approximately CZK 87 billion. Valuation changes, which do not affect M2 growth, account for approximately CZK 40 billion of this amount and the actual increase in these assets for CZK 44 billion. This trend is very surprising at first glance, since in a managed floating regime which for approximately one year has not been accompanied by any major interventions/foreign exchange purchases by the central bank, financial flows should be offset within the framework of the balance of payments, and net foreign assets should not grow 1 .

A more detailed analysis of the structure of net foreign assets reveals that their growth is largely associated with an increase in koruna net foreign assets (of approximately CZK 34 billion), especially short-term koruna claims on non-residents. This development in the area of koruna assets of banks vis-a-vis non-residents probably reflects the continuing low interest of domestic banks in providing credits to businesses. The current level of the state budget deficit and the overall public debt financing need continues to be significantly lower than the volume of free koruna funds of banks (see the volume of sterilisation at the CNB). Consequently, when the repo rate declines, banks look for an alternative use of free funds, so that, in addition to the declared interest in investment in government securities, there is also interest in investing korunas abroad 2 . This situation is accompanied by interest from some foreign entities in korunas because of the need to finance their purchases of capital stakes in Czech businesses and banks.

The increase in koruna assets of banks vis-a-vis non-residents (i.e. the growth in net foreign assets) need not be accompanied by foreign exchange operations with the central bank, since banks have at their disposal a sufficient volume of korunas in the form of CNB-bills. In reality, money creation can thus take place through the non-resident circle, leading to M2 growth. The pick-up in year-on-year M2 growth since the beginning of 1999 is thus about 50% due to the increase in koruna net foreign assets. The remaining part is attributable to the previous years low base. The M2 increases of approximately 10% thus, despite the expected slight rise in inflation in 2000, guarantee a relatively high level of real money balances, which, if this higher M2 growth rate is sustained, could have a major effect on future economic and monetary developments in the Czech Republic.

1 According to the theory, the monetary base and consequently the money supply therefore do not increase. However, on account of the volume of sterilised free liquidity of banks, the Czech banking system is far from being dependent on additional issue of korunas by the central bank, with the ensuing possible acceleration of money supply growth in the economy.
2 However, these operations do not lead to a decline in sterilised liquidity of banks at the CNB; the korunas are returned to the Czech Republic, either as resident or non-resident deposits at banks.