MONETARY POLICY REPORT | SPRING 2025 (appendix 1)
(authors: Pavla Netušilová, Renata Pašaličová, Zdeněk Pikhart)
In 2019, Czech public budgets were close to being balanced and general government debt was below 30% of GDP. Since then, however, the preparedness of public finances has been tested first by the Covid crisis and then by the energy crisis, in response to which governments generated wide structural deficits. The fiscal imbalance was effectively reduced by a consolidation package, which lowered the general government deficit to close to 2% of GDP last year. Since the pre-Covid years, however, the share of monetary financial institutions (MFIs) in public debt financing has risen appreciably. Despite the decline in the deficit, this has made a significant contribution to growth of money in the economy, with a potentially inflationary impact. In the years ahead, public budgets will face new challenges due to growth in defence spending. Demographic trends should not be overlooked either. This appendix thus examines the monetary implications of fiscal deficits, with an emphasis on increased defence expenditure and its possible financing, which is changing rapidly in the context of a relaxation of the fiscal rules and changes in EU funding.
The general government deficit is funded primarily by issuing government bonds. The amount of government bonds issued has almost doubled over the last five years and was close to CZK 3 trillion – or 38% of GDP – in 2024. The total general government debt reached 43.4% of GDP in this period. MFIs have been the main contributors to financing the general government deficit in recent years (see Chart 1). They thus currently hold about half of the total amount of government bonds in their portfolios. This represents a sizeable increase compared to previous years. Non-residents account for almost one-third and non-monetary financial institutions for most of the rest.
Chart 1 – MFIs have increased their government bond holdings in recent years
CZK billions; end-of-period positions
Chart 2 shows that bank financing of general government is roughly correlated with the general government budget balance. Despite the consolidation package, general government has recorded elevated deficits over the last year. This represents an upside risk to inflation, one that the Monetary Policy Risks Scoreboard has also long been indicating. The structural deficit will widen modestly in 2025 and 2026. This year, it will be close to the cap set out in the Act on Budget Responsibility. The persisting deficit thus implies an additional contribution of general government financing to growth in the quantity of money in the economy. Future growth in defence spending and relaxation of the fiscal rules may thus cause general government deficits to stay higher for longer.
Chart 2 – The general government structural deficit has been funded most of all by banks in recent years
% of GDP
The accounting scheme below illustrates the money growth mechanism when the general government deficit is funded by commercial banks or when there is a net inflow of funds from the EU. Banks finance purchases of government bonds on the primary market (case 1a, for illustration, e.g. CZK 100 billion) from an asset account containing liquidity deposited with the central bank. The government, for which the central bank keeps an account as part of its liabilities, gains (non-monetary aggregate) liquidity, against which a new liability arises. So far, this operation is within the financial system. A net inflow from the EU also increases the amount of government liquidity held in the central bank’s balance sheet liabilities (case 2, e.g. CZK 50 billion). The central bank’s international reserves rise at the same time. The central bank then converts the liquidity from euros to korunas off the foreign exchange market with no effect on the exchange rate. In both cases, it is only when government expenditure is realised from a resident (case 3, e.g. CZK 150 billion in total) that the liquidity is transferred back to commercial banks on the asset side of their balance sheet and the deposits of non-bank clients increase on the liability side. At this moment, there is an increase in the quantity of money in the economy as defined by M3. Purchases of government bonds by banks from non-banks on the secondary market also have a monetary impact.[1] This does not change the total liability of the government, but the change in bond holdings towards banks increases the deposits of these non-bank entities, which originally owned the bonds (case 1b, e.g. CZK 20 billion), and these are now part of the M3 money supply.
Scheme – Government bond purchases by banks and the subsequent realisation of public expenditure increase the money supply
Note: For illustration, the scheme gives the example of government investment expenditure, but any other type of expenditure or a reduction in the tax burden could be used. Initial balance on the “Debit” side (D) for asset accounts and on the “Credit” side (C) for liability accounts.
The recent elevated financing of fiscal deficits is creating an additional exogenous money growth factor (see Chart 3).[2] The contribution of general government financing by banks to M3 growth was 1.9 pp (about CZK 123 billion) on average in 2024, well above the long-term average (0.2 pp in 2010–2019), despite recording a modest year-on-year decrease. General government also obtains financing from abroad. This is reflected in growth in the quantity of money in the economy via a change in net foreign assets. The net debt of general government abroad went up slightly by CZK 12.3 billion in 2024. Debt financing of future defence spending would lead to additional growth in the quantity of money in the economy. Other things being equal, the latter is also increased by a net inflow of EU funds, although this would no longer involve additional money growth relative to the original allocation if the allocation were redirected from civilian projects to defence spending.
Chart 3 – Fiscal deficits have been a big contributor to money growth in recent years
annual rates of growth in %; contributions in pp
The relationship between the quantity of money in circulation and inflation shows considerable volatility. Earlier studies, such as the meta-analysis by Gertler and Hoffmann (2018),[3] documented an inverse relationship between money growth and inflation since the mid-1980s. However, a stronger link between money and inflation was identified in economies with higher inflation. Berger, Karlsson and Österholm (2023),[4] inspired by the surge in money growth and the rise in inflation after 2020, assessed the relation between these two variables using data for the euro area and the US. Their results confirm the previous study’s finding that the impact that a shock to money growth has on inflation varies considerably over time depending on the initial state of the economy and inflation. Borio, Hofmann and Zakrajšek (2023)[5] also confirm this non-linearity. The strength of the link between money growth and inflation depends on the level of inflation: it is one-to-one when inflation is high and virtually non-existent when it is low. In a high-inflation environment, looking at money growth can help to improve inflation forecasts. Additional money creation due to fiscal policy could thus have an inflationary effect especially in times of inflationary shocks in an environment of elevated inflation expectations.
Defence expenditure as a possible factor of general government deficits staying higher for longer
The current average EU defence spending of around 1.3% of GDP (data for 2023 according to the Classification of the Functions of Government, COFOG) seems insufficient in the context of the current geopolitical changes. For this reason, at the beginning of March 2025, the European Commission proposed new ways of financing additional defence spending, including a relaxation of the fiscal rules. This may cause a deterioration in public finances in EU Member States in the coming years. Some European countries neighbouring Russia (most notably the Baltic States and Poland) have sharply increased their defence spending since the outbreak of war in Ukraine in February 2022, but most other EU Member States have not. This is the case in the Czech Republic, where, as in the EU as a whole, general government spending is dominated by social spending, while defence funding is among the lowest items (see Chart 4). Growth in defence spending was not apparent in the Czech Republic until 2024, when it reached the required NATO minimum of 2% of GDP (see Chart 5). The present government, whose mandate ends in autumn 2025, has announced a plan to increase defence spending in NATO accounting terms. Defence expenditure is set to reach at least 2.2% of GDP by 2026 and go up by 0.2% of GDP annually and reach to 3.0% of GDP in 2030.
Chart 4 – Defence spending in the Czech Republic is among the categories with the lowest funding
% of GDP; COFOG methodology
Note: The three largest COFOG expenditure items cover social expenditure (all social benefits and pension insurance benefits), public health system funding and government subsidy policy. Changes in legislation during the Covid-19 pandemic and the energy crisis caused them to increase, strengthening the role of government in terms of the share of redistributed funds in relation to GDP. A return to their original level could thus provide room for growth in defence spending.
Chart 5 – Defence spending in the Czech Republic has mostly been rising since Russia annexed Crimea in 2014
% of GDP
Note: The NATO indicator captures defence spending according to actual, i.e. cash, expenditure. By contrast, the COFOG indicator is based on the accrual of expenditure flows (according to ESA 2010 national accounts methodology). In addition to different methods of recording defence spending, these indicators differ partly in terms of substance. The COFOG indicator is published with a lag of more than one year (t+15).
The European Commission is currently working on the legislative form of the proposals it presented in March 2025 as part of the ReArm Europe Plan. The Plan aims to support a massive long-term ramp-up of public and private[6] investment in defence. This will involve expanding the range of credit instruments (a new SAFE instrument[7] and a new area of European Investment Bank loans[8]) and more flexible use of the existing 2021–2027 cohesion policy funds. Given the growth in defence spending, the Commission envisages activating the national escape clauses of the Stability and Growth Pact, which will allow EU Member States to deviate by up to 1.5% of GDP from the annual net expenditure paths contained in their medium-term fiscal structural plans.[9] This deviation will include SAFE loans.
In this context, a proposal to amend the Law on Budgetary Rules has been passed in the Chamber of Deputies of the Czech Parliament extending the budget expenditure framework over the next eight years to include additional defence spending. Under this proposal, the difference between actual defence spending and 2% of GDP is not included in the expenditure limits. For example, with a 0.2% of GDP increase in defence spending next year, the effective cap on the structural deficit would shift to 1.95% of GDP in 2026 (from 1.75% of GDP). The amendment should take effect as soon as possible so that it can be used in the preparation of next year’s budget. Owing to the rising defence spending, the Czech Fiscal Council recommended a temporary relaxation of the rules of budgetary responsibility in its quarterly opinion of March 2025. However, it adds that, given the fiscal space, non-military spending will need to be reduced in the medium term.
The Czech Republic, along with Slovakia and Germany, has the lowest defence spending in the group of countries for which Russia represents a security threat (either countries directly neighbouring it or countries without a common border with it but with a political representation that considers the Russian threat to be real; see Chart 6). However, in the event of a sustained increase in defence spending in the EU, the European arms industry can be expected to see a revival in production. In its measures, the European Commission aims to support the domestic EU arms industry. This should lead to shorter delivery times and, in turn, faster spending on military contracts. In addition to the new EU loan sources, it will be possible to draw on existing unused cohesion policy funds, which, in the Czech Republic, amounted to 46% of the 2021–2027 cohesion policy allocation (i.e. CZK 241 billion) at the end of February 2025, and with no impact on the general government balance. A reallocation to defence in the existing operational programmes is already envisaged in the mid-term review of the 2021–2027 programming period, which should be approved in the coming months.
Chart 6 – A narrow majority of the EU Member States in NATO exceeded the NATO minimum of 2% of GDP in 2024
% of GDP
To sum up, in terms of monetary policy, the current public finance setup creates a creeping upside risk to inflation. In view of the changing security situation, which requires an increase in defence expenditure, and of the adverse demographic trends, the general government deficit is likely to remain elevated in the years ahead. A considerable amount of additional money will thus continue to be created in the economy. Its inflationary effects may be felt particularly acutely in fragile times when other inflationary shocks occur. This vulnerability stemming from elevated public finance deficits is cause for a cautious approach in the shape of a more restrictive monetary policy stance.
[1] This category also includes portfolio shifts between banks and non-banks (insurance companies and pension funds).
[2] The relatively low contribution of general government financing in net terms to M3 growth in 2020 reflected a sizeable accumulation of central government deposits, which were released into the economy only later. Debt financing of general government expenditure crowds out other private expenditure if the economy is close to, or above, its potential.
[3] See Gertler, P., and Hofmann, B. (2018): Monetary facts revisited, Journal of International Money and Finance.
[4] See Berger, H., Karlsson, S., and Österholm, P. (2023): A note of caution on the relation between money growth and inflation, IMF Working Paper.
[5] See Borio, C., Hofmann, B., and Zakrajšek, E. (2023): Does money growth help explain the recent inflation surge?, BIS.
[6] In mid-March 2025, the European Commission adopted a strategy for a Savings and Investments Union to channel more private investment into defence, among other things. However, some of the internally declared targets of financial institutions limit the access of investors in the defence industry to credit sources. The Commission believes that the regulation on sustainability-related disclosures in the financial services sector does not prevent the financing of defence expenditure, but an additional explanation of the correct application of this regulation could help the finance and defence sectors to function better. In this context, the Commission is considering making defence an explicit EU investment objective.
[7] The European Commission is proposing a new SAFE (Security Action for Europe) regulation aimed at providing up to EUR 150 billion of loans backed by the EU budget. The new instrument would support common procurement of defence products by at least two partner countries, at least one of which must be an EU Member State. EEA/EFTA countries and Ukraine can also participate.
[8] EIB shareholders have adopted an Action Plan to improve access to EIB financing for European security and defence firms. A proposal to double annual investments in the security and defence sector to EUR 2 billion and to change the EIB’s criteria for providing loans to this area is currently under preparation.
[9] Eurostat will introduce a data collection process in cooperation with the national statistical authorities. This will build on the COFOG category of “Defence”, while also considering the NATO definition.