What is “sterilization”
Sterilization is a form of monetary action in which a Central Bank seeks to limit the influence of the inflow and outflow of capital on the money supply. Sterilization often involves the purchase or sale of financial assets by the Central Bank, and is designed to compensate the effect of foreign exchange intervention. The process of sterilization is used to control the cost of one national currency against another, and it starts in the currency market.
Breaking down the ‘sterilization’
Sterilization requires a Central Bank to go beyond its national boundaries, including in foreign currency. As an example, consider the Federal reserve buying and selling of foreign currency, in this case the yen, and the purchase is made with dollars that the fed is in their reserves. The result of this action was less optimism on the market as a whole – he was placed in the reserves of the fed and more dollars because the dollars that were in reserve, the fed is now on the open market. To neutralize the effect of this transaction, the fed may sell government bonds, which removes dollars on the open market and replace them with government commitments.
Emerging markets can be subject to capital inflows when investors buy up the national currency for the purchase of domestic assets. For example, an American investor wants to invest in India must use the dollars to buy rupees. If many American investors are beginning to buy dollars, the exchange rate of rupee will increase. At this point, the Indian Central Bank may allow the oscillations continue, which could increase the value of Indian exports, or it can buy foreign currency from their reserves in order to reduce the rate. If the Central Bank decides to buy foreign currency, he can try to compensate for the increase of the RS on the market selling rupee-denominated government bonds.
Sterilization to prevent the increase of the currency.
The Central Bank may also intervene in currency markets to prevent appreciation of the national currency by selling its currency in exchange for foreign currency assets, thereby increasing their foreign reserves as a happy side effect. Because the Central Bank issues more of its currency in circulation, the money supply expands. The money spent initially buying foreign assets goes to other countries, but soon finds its way back into the domestic economy as payment for exports. The expansion of the money supply can lead to inflation, which could undermine the export competitiveness of the country as well as the rate increase.