The Relationship between the Output Gap and Excess Liquidity: Evidence from Czech Republic, Estonia and Kosovo

By Kastrati, Albulenë; Adnett, Nick et al. | Journal of Economics & Management, January 1, 2018 | Go to article overview

The Relationship between the Output Gap and Excess Liquidity: Evidence from Czech Republic, Estonia and Kosovo


Kastrati, Albulenë, Adnett, Nick, Toçi, Valentin, Journal of Economics & Management


1. Introduction

The desire to see banks lend more to the private sector is a familiar refrain in the transition context. Given that banks in European Transition Economies (ETEs) are proportionally lending less than their counterparts in the Eurozone in the face of seemingly profitable loan opportunities, then the question arises: is the output gap emanating from excess liquidity, or both are determined by a wider system?

Bank lending to the private sector is relatively low in ETEs, around 40 percent of GDP, average 2000-2014, compared to the lending in the Eurozone, around 93 percent of GDP (World Bank, 2015; European Central Bank [ECB], 2015). This low lending ratio becomes even more important for economic activity, given that banks in most ETEs are the main funding source, with capital markets being non-existent or only in their infancy. However, banks in many of the ETEs appear to be keeping reserves in excess of the Reserve Requirement Ratio required by the central bank as well as above the mandatory liquidity ratio. For example, over the span of 2000-2014, several ETEs have on average accumulated excess liquidity to total assets ratio of 19 percent, in the Czech Republic, Estonia and Kosovo this ratio was 14.2 percent, 5 percent and 25 percent, respectively. This may suggest that banks in ETEs could further extend their lending. Moreover, the net interest margin in ETEs was around 6.5 percent, compared to just 2.2 percent in the Eurozone, average 2000-2014 (World Bank, 2015; ECB, 2015).

Despite available funds and the seemingly profitable opportunities to expand lending, banks in many ETEs have persistently accumulated excess liquidity. Though part of this excess liquidity held may reflect profit-maximising banking behaviour and may simply be precautionary in nature, the involuntarily held part is an underutilised resource (Agenor, Aizenman, & Hoffmaister, 2004; Saxegaard, 2006). Excess liquidity in most cases is non-remunerated and even in the cases where they are remunerated the interest rates earned are very low. Thus, excess liquidity and less lending in the economy could be reflected in the output gap.

Some of the factors implying the presence of a large output gap in ETEs are relatively high unemployment rate (Kosovo 43 percent compared to an average of 9 percent in the Eurozone countries between 2000 and 2014) and around 20 percent unutilised capacity at firm level (European Bank for Reconstruction and Development [EBRD], 2009). Furthermore, the estimated results for the output gap for the selected ETEs, namely Czech Republic, Estonia and Kosovo, are ± 4 percent, 5.8 percent and 5 percent, respectively, as compared to the Eurozone 0.2 percent (average 2000-2013), suggesting that the output gap in ETEs may be relatively larger than those in the Eurozone. Furthermore, in transition economies the 'cycle' also reflects structural effects on potential output that may be reflected in the persistent underutilisation of resources, i.e. a negative output gap (Kastrati, Pugh, & Toçi, 2017).

Following the Global Financial Crisis (GFC) and the fiscal crises in Greece and other Eurozone countries, the concept of the output gap has regained attention as an indicator of the cyclical position of the economy. For example, the concept of the output gap has acquired operational but not legal consideration in the Growth and Stability Pact in European Union, as this measure provides an essential input for calculating indicators of the structural (i.e. cyclically adjusted) fiscal balance (European Commission, 2001; Billmeier, 2004). Several recent studies pay special attention to the cyclical position of the economy as proxied by the output gap (e.g. Organization for Economic Co-operation and Development [OECD], 2010; Roubini, 2015).

The majority of recent discussion has concentrated on finding a causal relationship between finance and growth and most studies conclude that financial markets have an impact on the real economy via financial accelerators, economic multipliers and/or amplification of financial shocks (Biggs & Mayer, 2013; Borio, Disyatat, & Juselius, 2013). …

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