What is sterilization?

Sterilization

Sterilization is a technique whereby the central bank of a country influences its exchange rate without changing the monetary base of the economy. Sterilization essentially involves two steps:

1. Sale (if domestic currency is depreciating) or purchase (if domestic currency is appreciating) of foreign currency assets (FCAs)
2. Open market operations (OMOs) involving purchase (if domestic currency is depreciating) or sale (if domestic currency is appreciating) of domestic currency securities/bonds, of the same size as in the first transaction.

Let us take an example to understand the above transactions and their impact in a better manner. Assume Indian Rupee is appreciating against US dollar. The central bank of India, RBI, feels it needs to curb this appreciation.

1. RBI buys dollar from the market in exchange for rupees through state run banks. This curbs rupee appreciation but it also has an impact of increasing the monetary base and hence inflation as the supply of rupee has increased.
2. So to nullify the unintended impact of increased monetary base, the central bank (RBI in this example) undertakes selling of bonds denominated in domestic currency, in the same amount as infused by it while buying dollars. This helps in taking out the excess cash from the market which the Central Bank injected through the purchase of Foreign currency asset (US Dollar in this case). So when these two steps are carried simultaneously, the net effect is controlling the exchange rate of the country while also ensuring that monetary base is left unchanged and that the inflation is kept under control.

RBI in effect has also replaced rupee denominated securities in its portfolio with dollar denominated securities. If only the first step is undertaken, it is called unsterilized intervention. This is so as in this scenario, the central bank has intervened in the market to control the exchange rate, but its side impact of increasing the monetary base in the economy is not counterbalanced and hence the term unsterilized is used for the same.

Instruments for Sterilization: 

• Liquidity adjustment facility (LAF)

This is a tool used by the central bank for the liquidity management of the currency of its economy. Under LAF, banks are allowed to borrow money through repurchase agreements.

• Open market operations (OMO) 

This is a method in which the central banks indulge in outright sale/ purchase of securities, to absorb/infuse the excess liquidity from/into the market.

• Balances of government with the central bank

Surplus balance of government kept with RBI can also be used for sterilization.

• Forex swaps 

Some central banks also use forex swaps which help in the postponement of creation/absorption of liquidity and the consequent increase/decrease of reserves.

• Cash reserve requirements

CRR can also be used as an instrument to raise/ reduce the proportion of NDTL of banks.