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.
BREAKING DOWN 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 purchasing a foreign currency, in this case the yen, and the purchase is made with dollars that the Fed had 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.
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 lots 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.
Sterilization to Prevent Currency Appreciation
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.