Evaluating the Links Between the Financial and Real Sectors in a Small Open Economy: The Case of the Czech Republic

Various approaches have been employed to study the possibility of non-linear feedback between the real and financial sector. We employ the threshold Bayesian VAR with block restrictions to evaluate the non-linear dynamics in a small open economy using the example of the Czech Republic. The study combines information on aggregate credit and non-performing loans (NPLs) to find that procyclicality of the financial sector matters for the real economy. A positive shock to credit and a negative shock to NPLs support industrial production over the entire time horizon, yet the responses do not differ substantially across credit spread regimes. Our results also suggest that the responses of the financial sector to real shocks differ depending on the credit market conditions. Finally, the direct impact of foreign factors on lending seems to be rather limited given that the financial sector in the Czech Republic is largely bank-based and funded predominantly by domestic deposits.