## Robustness Check of FX Market Shallowness

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**Canonical URL:** [Robustness Check of FX Market Shallowness](https://www.imf.org/-/media/files/publications/selected-issues-papers/2026/english/sipea2026034.pdf)

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---

### Executive summary
- The paper applies the IMF’s Integrated Policy Framework (IPF) to the Czech Republic using an extended QIPF model to assess policy tradeoffs under tail-risk scenarios.
- Main identified friction: some shallowness of FX markets.
- Key model-consistent findings:
  - In a global risk-off outflow shock, combined use of reserves and interest rate policy can improve macro stabilization.
  - Refocusing fiscal stimulus toward productive capital expenditure greatly reduces the degree of monetary policy tightening needed to stabilize inflation at target.
  - CNB balance sheet normalization is optimally implemented if preannounced and gradual; potential currency appreciation can be mitigated through a slightly lower policy rate.

### Institutional setup and FX market depth
- Monetary framework and instruments:
  - CNB inflation target: 2 percent.
  - Main instrument: monetary policy interest rate via two-week repo operations.
  - CNB can intervene in FX markets to address excessive volatility or disorderly market conditions.
- Intervention history:
  - Large scale FX interventions occurred during 2013–2017 (koruna floor vs euro) and in 2022 (energy crisis).
- FX market structure and depth:
  - CZK trading concentrated in EUR/CZK; FX swaps have highest turnover, followed by spot and forwards.
  - Bid-ask spread on CZK: around 10 basis points (wider than comparable currencies).
  - Empirical indicators present a mixed picture but suggest some lack of depth that can worsen during stress.

### Foreign currency balance-sheet positions
- Central bank reserves:
  - CNB reserve holdings: about 43 percent of GDP.
- Net foreign currency positions:
  - Non-financial sector external foreign currency assets: approximately 40 percent of GDP.
  - Foreign currency liabilities: 16 percent of GDP.
- Banking and corporate exposures:
  - Nine of the ten largest banks are foreign-owned; more than 90 percent of total banking assets under foreign ownership.
  - Share of foreign currency loans to non-financial corporations: nearly 50 percent of total corporate lending, equivalent to around 10 percent of GDP.
  - Supervisory guidance restricts foreign-currency lending to firms with a natural hedge, mitigating balance-sheet mismatch risks.

### Inflation expectations and exchange-rate pass-through
- Measured pass-through:
  - Local projections’ estimates: pass-through of roughly 0.06 after 12 months and 0.2 after 36 months.
  - Literature findings cited: Kucharčuková (2017) under 0.1 (most effect within first three months); Hájek and Horváth (2015) long-run ≈ 0.5 with peak at 9–13 months.
- Anchoring and dynamics of expectations:
  - Inflation expectations generally well anchored but can deviate from target for extended periods.
  - Households’ expectations are backward-looking and adaptive.
  - Granger causality: inflation leads inflation expectations, not vice versa.
  - Persistence: inflation expectations half-life of about eight months (faster decay than actual inflation).

### QIPF model implementation and scenario design
- Model characteristics:
  - QIPF is a New Keynesian open-economy model with TANK-type households (hand-to-mouth and Ricardian) and limited risk-bearing capacity for FX traders.
  - Estimated using quarterly data for 2000–2025 with Bayesian techniques.
  - Estimated properties: FX market moderately shallow; exchange-rate pass-through gradual; medium-term inflation expectations reasonably well-anchored.
- Simulated scenarios:
  - Scenario 1 — Global financial risk-off shock (non-fundamental): generates capital outflow, CZK depreciation, sharp increase in the UIP premium.
  - Scenario 2 — Expansionary fiscal policy shock (fundamental): two variants
    - (i) fiscal expansion driven mainly by current expenditure with limited productivity effects;
    - (ii) fiscal expansion driven primarily by capital expenditure yielding positive productivity and potential output effects.
  - Scenario 3 — CNB balance sheet reduction: explores implications of reducing FX reserves under different unwinding paces and FX market depth assumptions.

### Scenario 1 — Global non-fundamental financial risk-off shock: transmission and policy tradeoffs
- Shock characteristics:
  - Global shock is non-fundamental, driven by a broad repricing of global financial assets that triggers capital outflows from the Czech Republic and CZK depreciation.
  - FX market depth is assumed to temporarily decline as a direct consequence of the global shock.
  - Episodes of capital outflows and currency depreciation have occurred in the Czech Republic, most recently as a result of the US tariff announcements in early April 2025.
- Transmission:
  - CZK depreciation raises inflation and increases the risk that inflation expectations become de-anchored and rise persistently above the CNB’s inflation target.
  - Inherent challenge: transmission lags between high-frequency financial market movements and lower-frequency availability of inflation and expectations data.
- QIPF model results and policy tradeoffs:
  - A combination of policy rate tightening and selling of foreign currency (FXI) delivers the most effective macroeconomic stabilization compared to relying on policy rate tightening alone.
  - Joint use of policy rate tightening and FXI reduces both the rise in inflation and output loss because the required interest rate increase is smaller when FXI offsets the surge in the UIP premium.
  - Some policy rate tightening is useful if there is a risk of de-anchoring of inflation expectations.
  - Financial stability considerations:
    - Financial stability risks related to CZK depreciation remain contained given the absence of significant FX balance sheet mismatches in the economy.
    - Tighter monetary policy itself could heighten domestic financial stability risks; these can be mitigated ex-post through FXI or ex-ante through macro-prudential tools such as DTI and DSTI limits.
  - Reserves and mandate:
    - The CNB holds ample FX reserves to withstand such a global external shock.
    - Using FXI in response to a non-fundamental global shock that generates disorderly market conditions would be consistent with the IPF and with the CNB’s mandate.
- Robustness (Box 1):
  - Baseline uses FX market shallowness between lower liquidity typical of small emerging economies in CEEC and higher liquidity estimated for Small Open Advanced Economies.
  - If FX markets are deeper:
    - Combination of policy rate tightening and FXI still most effective.
    - Impact on exchange rate, UIP premium, and inflation would be less.
    - FXI itself would be less effective, suggesting a more limited case for using FXI.

### Scenario 2 — Fiscal expansion (government expenditure increases by 1.5 percent of GDP)
- Simulation design:
  - Government expenditure increases by 1.5 percent of GDP over one year.
- Key outcomes:
  - Raises consumption, output and inflation, with modest CZK depreciation in the near-term.
  - Government debt rises in the medium-term.
  - UIP premium moves very little; FXI is not used to counteract domestic fiscal expansion, especially when fiscal expansion contributes to macroeconomic imbalances.
- Two variants and CNB response:
  - Current expenditure expansion, no productivity effects:
    - Immediate boost to output and consumption; modest deterioration in trade balance; CZK weakens marginally.
    - Potential output rises briefly, then fades; inflation increases.
    - Estimated CNB response: tighten policy rates sufficiently to bring inflation back to target.
  - Capital expenditure expansion with productivity and potential output gains:
    - Increases productivity and potential output; monetary policy needs to tighten less in the near-term and may even ease in the medium-term.
    - Consumption and output rise above the baseline on a sustained basis.
    - Increase in government debt would be less than in scenarios without productivity gains.

### Scenario 3 — CNB balance sheet reduction (reduce reserves from about 45 percent of GDP to 30 percent of GDP)
- General setup:
  - CNB preannounces intention and path for reducing reserves by one third — from the current level of about 45 percent of GDP to 30 percent of GDP — leaving ample reserves remaining to withstand shocks.
- Front-loaded approach (rapid decline in reserves over one year):
  - Assumes FX market depth is limited and markets cannot fully absorb speedy large CNB FX sales.
  - QIPF-generated outcomes:
    - Strong and front-loaded appreciation of the CZK.
    - Substantial decline in inflation, prompting significant policy rate easing in response to the disinflationary impact.
    - Consumption and output rise initially due to easing of monetary policy; exports gradually fall and the trade balance deteriorates over time.
- Gradual approach (gradual reduction over a three-year period):
  - Assumes FX markets can absorb gradual FX sell-off.
  - QIPF-generated outcomes:
    - CZK appreciates during the first year to a lesser extent than under the front-loaded scenario.
    - More moderate and manageable impact on output and core inflation.
    - Smaller deterioration in the trade balance.
    - Modest and gradual policy rate easing over the simulation horizon.
- Policy tradeoff highlighted:
  - A preannounced and gradual approach provides a more stable macroeconomic adjustment path and leaves ample reserves to withstand shocks.
  - The model indicates a CZK nominal appreciation of approximately 6 percent under the gradual scenario could be neutralized with an additional 70 bp policy rate reduction during the first 3 years (normal forecast horizon).
  - While not posing immediate financial stability risks, the CNB may consider activating ex-ante macroprudential tools such as DTI and DSTI limits should lower lending rates contribute to an undesirable buildup in credit.

### Conclusions and policy implications
- Utility of the IPF/QIPF:
  - The IMF’s IPF can support scenario analysis and help assess policy tradeoffs and impacts when simulating risks around the baseline or conducting policy simulations.
- Main frictions and vulnerabilities:
  - The Czech economy is a small open advanced economy with some shallowness of FX markets identified as the main friction under the IPF.
  - No evidence of FX balance sheet mismatches, nor of any major risk of de-anchoring of inflation expectations; overall frictions that amplify shocks or alter policy tradeoffs are modest.
- Policy prescriptions under different shocks:
  - In the event of global asset valuation corrections leading to currency depreciation, a combination of policy rate tightening and FXI delivers the most effective macroeconomic stabilization versus relying solely on policy rate tightening.
  - The monetary policy response to fiscal stimulus depends on the composition of the expansion: tighter monetary policy if stimulus contributes to macroeconomic imbalances; more muted response when stimulus raises productivity.
  - A gradual and preannounced reduction of CNB FX reserves offers a more manageable macro environment; modest additional policy rate easing can offset CZK appreciation if monetary policy space allows.
  - Early introduction of macroprudential measures could help mitigate emerging vulnerabilities.

*Source: IMF staff simulations and analysis as presented in sipea2026034.*

### 1. Robustness Check of FX Market Shallowness_________________________________________ 11

### 1. Robustness Check of FX Market Shallowness

### Executive summary
- The paper applies the IMF’s Integrated Policy Framework (IPF) to the Czech Republic using an extended QIPF model to assess policy tradeoffs under tail-risk scenarios.
- Main identified friction: some shallowness of FX markets.
- Key model-consistent findings:
  - In a global risk-off outflow shock, combined use of reserves and interest rate policy can improve macro stabilization.
  - Refocusing fiscal stimulus toward productive capital expenditure greatly reduces the degree of monetary policy tightening needed to stabilize inflation at target.
  - CNB balance sheet normalization is optimally implemented if preannounced and gradual; potential currency appreciation can be mitigated through a slightly lower policy rate.

### Institutional setup and FX market depth
- Monetary framework and instruments:
  - CNB inflation target: 2 percent.
  - Main instrument: monetary policy interest rate via two-week repo operations.
  - CNB can intervene in FX markets to address excessive volatility or disorderly market conditions.
- Intervention history:
  - Large scale FX interventions occurred during 2013–2017 (koruna floor vs euro) and in 2022 (energy crisis).
- FX market structure and depth:
  - CZK trading concentrated in EUR/CZK; FX swaps have highest turnover, followed by spot and forwards.
  - Bid-ask spread on CZK: around 10 basis points (wider than comparable currencies).
  - Empirical indicators present a mixed picture but suggest some lack of depth that can worsen during stress.

### Foreign currency balance-sheet positions
- Central bank reserves:
  - CNB reserve holdings: about 43 percent of GDP.
- Net foreign currency positions:
  - Non-financial sector external foreign currency assets: approximately 40 percent of GDP.
  - Foreign currency liabilities: 16 percent of GDP.
- Banking and corporate exposures:
  - Nine of the ten largest banks are foreign-owned; more than 90 percent of total banking assets under foreign ownership.
  - Share of foreign currency loans to non-financial corporations: nearly 50 percent of total corporate lending, equivalent to around 10 percent of GDP.
  - Supervisory guidance restricts foreign-currency lending to firms with a natural hedge, mitigating balance-sheet mismatch risks.

### Inflation expectations and exchange-rate pass-through
- Measured pass-through:
  - Local projections’ estimates: pass-through of roughly 0.06 after 12 months and 0.2 after 36 months.
  - Literature findings cited: Kucharčuková (2017) under 0.1 (most effect within first three months); Hájek and Horváth (2015) long-run ≈ 0.5 with peak at 9–13 months.
- Anchoring and dynamics of expectations:
  - Inflation expectations generally well anchored but can deviate from target for extended periods.
  - Households’ expectations are backward-looking and adaptive.
  - Granger causality: inflation leads inflation expectations, not vice versa.
  - Persistence: inflation expectations half-life of about eight months (faster decay than actual inflation).

### QIPF model implementation and scenario design
- Model characteristics:
  - QIPF is a New Keynesian open-economy model with TANK-type households (hand-to-mouth and Ricardian) and limited risk-bearing capacity for FX traders.
  - Estimated using quarterly data for 2000–2025 with Bayesian techniques.
  - Estimated properties: FX market moderately shallow; exchange-rate pass-through gradual; medium-term inflation expectations reasonably well-anchored.
- Simulated scenarios:
  - Scenario 1 — Global financial risk-off shock (non-fundamental): generates capital outflow, CZK depreciation, sharp increase in the UIP premium.
  - Scenario 2 — Expansionary fiscal policy shock (fundamental): two variants
    - (i) fiscal expansion driven mainly by current expenditure with limited productivity effects;
    - (ii) fiscal expansion driven primarily by capital expenditure yielding positive productivity and potential output effects.
  - Scenario 3 — CNB balance sheet reduction: explores implications of reducing FX reserves under different unwinding paces and FX market depth assumptions.

### Key policy-relevant findings and recommendations
- Use of FX reserves plus interest rate policy:
  - In a global risk-off outflow, combining reserves usage with interest rate adjustments improves macro stabilization relative to relying solely on interest rate policy.
- Fiscal policy composition matters:
  - Redirecting fiscal stimulus toward productive capital expenditure materially reduces the required monetary tightening to bring inflation back to target.
- Balance sheet normalization:
  - Optimal approach is preannounced and gradual reduction of reserves.
  - Potential currency appreciation from reserve unwinding can be mitigated by a slightly lower policy rate in principle.
- Role of supervisory and ex-ante policies:
  - Strong supervisory guidance on foreign-currency lending and ex-ante measures (structural policies, macroprudential measures) remain important to limit frictions emphasized in the IPF.

*Source: March 4, 2026, SCENARIO ANALYSIS FOR THE CZECH REPUBLIC – USING THE INTEGRATED POLICY FRAMEWORK (IPF), IMF.*

### 21. Under adverse scenario 1, the CZK depreciates (rise in UIP premium) due to shallow FX

### 21. Under adverse scenario 1, the CZK depreciates (rise in UIP premium) due to shallow FX markets, and this depreciation spills over into a spike in inflation and the risk of above-target inflation expectations.

### Scenario 1: Global non-fundamental financial risk-off shock
- Shock characteristics
  - Global shock is non-fundamental, driven by a broad repricing of global financial assets that triggers capital outflows from the Czech Republic and CZK depreciation.
  - FX market depth is assumed to temporarily decline as a direct consequence of the global shock, consistent with evidence of moderately shallow FX markets.
  - Episodes of capital outflows and currency depreciation have occurred in the Czech Republic, most recently as a result of the US tariff announcements in early April 2025.
- Transmission
  - CZK depreciation raises inflation and increases the risk that inflation expectations become de-anchored and rise persistently above the CNB’s inflation target.
  - Inherent challenge: transmission lags between high-frequency financial market movements and lower-frequency availability of inflation and expectations data.

### QIPF model results and policy tradeoffs (Scenario 1)
- Policy instrument comparison (as simulated by the QIPF model)
  - A combination of policy rate tightening and selling of foreign currency (FXI) delivers the most effective macroeconomic stabilization compared to relying on policy rate tightening alone.
  - Joint use of policy rate tightening and FXI reduces both the rise in inflation and output loss because the required interest rate increase is smaller when FXI offsets the surge in the UIP premium.
- Role of policy rate tightening
  - Some policy rate tightening is useful if there is a risk of de-anchoring of inflation expectations.
- Financial stability considerations
  - Financial stability risks related to CZK depreciation remain contained given the absence of significant FX balance sheet mismatches in the economy.
  - Tighter monetary policy itself could heighten domestic financial stability risks (e.g., mortgages or consumer lending); these can be mitigated:
    - ex-post through FXI, resulting in less policy rate tightening, or
    - ex-ante through macro-prudential policy tools such as DTI and DSTI limits.
- Reserves and mandate
  - The CNB holds ample FX reserves to withstand such a global external shock.
  - Using FXI in response to a non-fundamental global shock that generates disorderly market conditions would be consistent with the IPF and with the CNB’s mandate.

### Box 1 — Robustness check of FX market shallowness
- Baseline assumption
  - Uses a measure of FX market shallowness between lower liquidity typical of small emerging economies in CEEC and higher liquidity generally estimated for Small Open Advanced Economies.
  - Assumption consistent with empirical findings for the Czech Republic and with FX markets becoming increasingly illiquid during a global risk-off shock.
- Robustness result
  - If scenario 1 is implemented with an assumption of deeper FX markets:
    - A combination of policy rate tightening and FXI still delivers the most effective macroeconomic stabilization.
    - The impact on the exchange rate, the UIP premium, and inflation would be less.
    - FXI itself would be less effective, suggesting a more limited case for using FXI.

### Scenario 2 (Fiscal expansion) — brief summary of implications for policy response
- Simulation design
  - Government expenditure increases by 1.5 percent of GDP over one year.
- Key outcomes
  - Raises consumption, output and inflation, with modest CZK depreciation in the near-term.
  - Government debt rises in the medium-term.
  - UIP premium moves very little; FXI is not used to counteract domestic fiscal expansion, especially when fiscal expansion contributes to macroeconomic imbalances.
- Two variants and CNB response
  - Current expenditure expansion, no productivity effects
    - Immediate boost to output and consumption; modest deterioration in trade balance; CZK weakens marginally.
    - Potential output rises briefly (higher labor supply), then fades; inflation increases.
    - Estimated CNB response: tighten policy rates sufficiently to bring inflation back to target.
  - Capital expenditure expansion with productivity and potential output gains
    - Increases productivity and potential output; monetary policy needs to tighten less in the near-term and may even ease in the medium-term.
    - Consumption and output rise above the baseline on a sustained basis.
    - Increase in government debt would be less than in scenarios without productivity gains.

### Scenario 3 (CNB balance sheet reduction) — approaches and outcomes
- General setup
  - CNB preannounces intention and path for reducing reserves by one third — from the current level of about 45 percent of GDP to 30 percent of GDP — leaving ample reserves remaining to withstand shocks.
- Front-loaded approach (rapid decline in reserves over one year)
  - Assumes FX market depth is limited and markets cannot fully absorb speedy large CNB FX sales.
  - QIPF-generated outcomes:
    - Strong and front-loaded appreciation of the CZK.
    - Substantial decline in inflation, prompting significant policy rate easing in response to the disinflationary impact.
    - Consumption and output rise initially due to easing of monetary policy; exports gradually fall and the trade balance deteriorates over time.
- Gradual approach (gradual reduction over a three-year period)
  - Assumes FX markets can absorb gradual FX sell-off.
  - QIPF-generated outcomes:
    - CZK appreciates during the first year to a lesser extent than under the front-loaded scenario.
    - More moderate and manageable impact on output and core inflation.
    - Smaller deterioration in the trade balance.
    - Modest and gradual policy rate easing over the simulation horizon.
- Policy tradeoff highlighted
  - A preannounced and gradual approach provides a more stable macroeconomic adjustment path and leaves ample reserves to withstand shocks.
  - The model indicates a CZK nominal appreciation of approximately 6 percent under the gradual scenario could be neutralized with an additional 70 bp policy rate reduction during the first 3 years (normal forecast horizon).
  - While not posing immediate financial stability risks, the CNB may consider activating ex-ante macroprudential tools such as DTI and DSTI limits should lower lending rates contribute to an undesirable buildup in credit.

### Conclusions and policy implications
- Utility of the IPF/QIPF
  - The IMF’s IPF can support scenario analysis and help assess policy tradeoffs and impacts when simulating risks around the baseline or conducting policy simulations.
- Main frictions and vulnerabilities
  - The Czech economy is a small open advanced economy with some shallowness of FX markets identified as the main friction under the IPF.
  - No evidence of FX balance sheet mismatches, nor of any major risk of de-anchoring of inflation expectations; overall frictions that amplify shocks or alter policy tradeoffs are modest.
- Policy prescriptions under different shocks
  - In the event of global asset valuation corrections leading to currency depreciation, a combination of policy rate tightening and FXI delivers the most effective macroeconomic stabilization versus relying solely on policy rate tightening.
  - The monetary policy response to fiscal stimulus depends on the composition of the expansion: tighter monetary policy if stimulus contributes to macroeconomic imbalances; more muted response when stimulus raises productivity.
  - A gradual and preannounced reduction of CNB FX reserves offers a more manageable macro environment; modest additional policy rate easing can offset CZK appreciation if monetary policy space allows.
  - Early introduction of macroprudential measures could help mitigate emerging vulnerabilities.

*Source: IMF staff simulations and analysis as presented in sipea2026034.*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2026/english/sipea2026034.pdf_