Banking system liquidity absorption and monetary base backing in the context of exchange rate policy in the Czech Republic, Poland and Hungary

Abstract

This article deals with the choice of exchange rate regime in transition economies, accumulation of foreign exchange (FX) reserves in balance sheets of central banks and its consequences in overall excess banking system liquidity. The case of banking system liquidity surplus is analysed focusing on creation of liquidity through FX intervention in a regime of fixed or managed exchange rates. In addition the article focuses on the main sources of liquidity absorption in the long run and on stability of monetary base backing by net foreign assets of the central bank in the context of trend appreciation of the domestic currency typical for transition economies. Last but not least, the article examines the speed of FX reserves decline in emerging FX markets and the implications of the exchange rate regime for both exchange rate volatility and foreign exchange market structure. The problems are analysed and compared using the examples of the Czech Republic (CR), Poland and Hungary in 1999–2009. The analysis focuses on the main differences in exchange rate policies, the level of liquidity surplus, cost of sterilisation, main sources of liquidity absorption and volatility of exchange rates. We find that absorption is influenced by the volume of excess liquidity and cost of sterilisation, which reflect the level of the main policy rate. The trend growth of currency in circulation is a key source of liquidity absorption in all central banks. Decline of FX reserves is a limited source of absorption owing to the lower liquidity of FX markets in the CR, Poland and Hungary. It is not possible to confirm a hypothesis of higher exchange rate volatility under floating regimes in CR and Poland as the Hungarian forint in a fixed rate regime suffers from higher volatility due to macroeconomic instability. Trend appreciation causes a decrease in the backing of the monetary base by net foreign assets but still both currency in circulation and banks' reserves are fully backed by net foreign assets of central banks.

Acknowledgement

This article is an output of the research project ‘Instability of financial market and effectiveness of its regulation’, registered by Grant Agency of the Czech Republic under the registration number 402/10/0289.