Sterilization: Definition and Example in Foreign Exchange

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 is a monetary action used by central banks in order to stem the negative effects emerging from capital inflows or outflows from a country's economy.
  • Classical sterilization involves central banks conducting buy and sell operations in open markets.
  • Usually, central banks modify classical sterilization by including fiscal policy measures in order to overcome problems like inflation.

Understanding Sterilization

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.

Problems with 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.

Special Considerations

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 of Sterilization

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.