- What Is Sterilization?
- How Sterilization Works in Foreign Exchange
- Challenges and Limitations of Sterilization
- Strategic Alternatives and Considerations for Sterilization
- Example: Sterilization in Emerging Markets
- What Is the Sterilization of the Economy?
- What Is Foreign Exchange Intervention?
- Does the Fed Buy Foreign Currency?
- The Bottom Line
What Is Sterilization?
Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply. Sterilization most frequently involves the purchase or sale of financial assets by a central bank and is designed to offset the effect of foreign exchange intervention. The sterilization process is used to manipulate the value of one domestic currency relative to another and is initiated in the foreign exchange market.
Key Takeaways
- Sterilization involves central banks buying and selling financial assets to offset capital flow effects on the money supply.
- Classical sterilization typically involves central banks using open market operations to neutralize capital inflows and outflows.
- Foreign exchange intervention is linked to sterilization, aiming to stabilize currencies amid market fluctuations.
- Some countries may face challenges with sterilization if they lack integration with global markets or sophisticated financial tools.
- Central banks may combine sterilization with easing capital controls and reserve requirements to manage economic stability.
How Sterilization Works in Foreign Exchange
Sterilization requires a central bank to look beyond its national borders by getting involved in foreign exchange.
As an example, consider the Federal Reserve (Fed) purchasing foreign currency, in this case the yen, with dollars that it has in its reserves. This action results in there being less yen in the overall market—it has been placed in reserves by the Fed—and more dollars, since the dollars that were in the Fed’s reserve are now in the open market.
To sterilize the effect of this transaction, the Fed can sell government bonds, which removes dollars from the open market and replaces them with a government obligation.
Challenges and Limitations of Sterilization
In theory, classical sterilization, such as the one described above, should counteract the negative effects of capital inflows. However, that may not always be the case in practice.
A central bank can also intervene in foreign exchange markets to prevent currency appreciation by selling its own currency in exchange for foreign currency-denominated assets, thereby building up its foreign reserves as a happy side effect. Because the central bank releases more of its currency into circulation, the money supply expands.
Money spent buying foreign assets initially goes to other countries, but it soon finds its way back into the domestic economy as payment for exports. The expansion of the money supply can cause inflation, which can erode a nation’s export competitiveness just as much as currency appreciation would.
The other problem with sterilization is that some countries may not have the tools to effectively execute sterilization in open markets. A country that is not fully integrated with the world economy may find it difficult to conduct operations in the open market.
For example, developing countries may not have sophisticated financial instruments to offer for investment to foreign investors. Central banks may also have to deal with operating losses since they are required to conduct transactions in foreign currencies for their portfolio of assets. This problem can be especially big for developing countries due to the imbalance in exchange rates.
Strategic Alternatives and Considerations for Sterilization
To overcome these problems, countries often resort to strategies that combine classical sterilization with other measures. For example, they might ease capital controls and reserve requirements at domestic financial institutions to encourage outflows and bring balance into the economy.
They may also conduct foreign exchange swaps by selling foreign currency against the local one and promising to buy it back at a later date. Other tools in a central bank’s policy arsenal are shifting public sector deposits from commercial banks to the central bank and making it difficult for the general public to access credit.
Example: Sterilization in Emerging Markets
Emerging markets can be exposed to capital inflows when investors buy up domestic currencies in order to purchase domestic assets. For example, a U.S. investor looking to invest in India must use dollars to purchase rupees. If a lot of U.S. investors start buying up rupees, the rupee exchange rate will increase.
At this point, the Indian central bank can either let the fluctuation continue, which can drive up the price of Indian exports, or it can buy foreign currency with its reserves in order to drive down the exchange rate. If the central bank decides to buy foreign currency, it can attempt to offset the increase of rupees in the market by selling rupee-denominated government bonds.
What Is the Sterilization of the Economy?
Sterilization refers to actions that central banks may take to ease the effects of capital inflows or outflows. Consider for instance the case of a country that faces a sudden inflow of capital. This can be destabilizing, with potential effects like inflation and the driving up of the price of exports. Sterilization of the economy is an attempt to offset such effects.
What Is Foreign Exchange Intervention?
Foreign exchange intervention is a concept closely linked to economic sterilization. Such intervention refers to monetary policies that central banks adopt to stabilize currencies in the face of both market and non-market headwinds.
Does the Fed Buy Foreign Currency?
The Federal Reserve (Fed) may engage in foreign exchange transactions to stabilize markets as needed. Typically, the Fed’s interventions are aimed at reducing volatility of exchange rates. Transactions are conducted by the Federal Reserve Bank of New York.
The Bottom Line
Sterilization refers to actions that central banks take to counteract the effects that inflow and outflow of capital can have on the money supply. This typically involves buying and selling financial assets to offset the impact of foreign exchange activities. For some countries, sterilization is just one monetary tool, often used in conjunction with others such as the easing of capital controls and reserve requirements.
