Sterilization is an important concept in economics and finance that refers to actions taken by central banks to neutralize or counteract the effects of external monetary flows on the money supply. When a country runs a balance of payments surplus or deficit, there can be large capital inflows or outflows that affect domestic money supply and interest rates. Sterilization helps insulate an economy from these flows and maintain control over monetary policy.

What is Sterilization in Economics?

Sterilization is a central banking operation that aims to prevent changes in the money supply from affecting the overall economy. It involves countering the effects of external capital flows so that domestic objectives like inflation targeting or exchange rate management can be achieved.

There are two main types of sterilization:

Outward Sterilization

This happens when a central bank seeks to prevent foreign exchange inflows from increasing the money supply and driving down interest rates. It does this by selling bonds to mop up the excess liquidity.

For example, if a trade surplus leads to greater demand for a country’s currency and large capital inflows, the central bank can sterilize this by issuing debt securities and draining the surplus liquidity. This prevents cheap money fueling inflation.

Inward Sterilization

This involves preventing foreign exchange outflows from decreasing money supply and driving up interest rates. It is done by buying bonds to inject liquidity into the financial system.

For instance, if an economic crisis leads to capital flight out of a country, the central bank can sterilize the impact by purchasing bonds using foreign exchange reserves. This offsets the liquidity crunch.

In both cases, the goal is to maintain appropriate monetary conditions consistent with baseline policies. Sterilization allows central banks to retain control over the money supply and key rates like policy interest rates.

Why is Sterilization Used in Economics?

There are several key reasons sterilization operations are used as an economic practice:

1. Preserve Monetary Autonomy

Central banks have domestic targets for money supply, interest rates, inflation etc. Large capital flows can disrupt their monetary control and force them to adjust baseline policies. Sterilization helps nullify these external pressures.

For example, the People’s Bank of China has historically sterilized large dollar inflows to maintain control over CNY exchange rates and money supply.

2. Reduce Currency Appreciation or Depreciation

Significant foreign capital inflows tend to raise demand for the local currency, leading to appreciation. Outflows do the opposite. Sterilization helps counteract these exchange rate pressures.

Many Asian economies like Singapore, Hong Kong and Thailand have resorted to sterilization to contain rapid currency appreciation resulting from capital account surpluses.

3. Contain Asset Price Inflation

Capital inflows often find their way into real estate, stock markets and other asset classes, inflating valuations. Sterilization helps prevent excess liquidity from driving asset price bubbles.

When Swiss franc appreciation led to huge capital inflows after the Eurozone crisis, the Swiss central bank sterilized the flows to avoid overheating its property markets.

4. Maintain Financial and Economic Stability

Sudden stops in capital flows due to crises can destabilize economies by drying up liquidity. Inward sterilization using reserves helps manage these dislocations. It also prevents uncontrolled outflows during capital flight.

Key Sterilization Techniques Used by Central Banks

Central banks have several tools at their disposal to sterilize the effects of external capital flows:

1. Open Market Operations

This refers to buying and selling of government securities by the central bank to manage money supply and liquidity conditions. Securities are sold to mop up inflows or bought to add liquidity.

For example, the Reserve Bank of India regularly conducts open market sales of Treasury bills and bonds to sterilize the impact of foreign fund inflows.

2. Increase Reserve Requirements

Higher reserve ratio mandates force banks to keep a larger share of deposits with the central bank. This drains excess liquidity arising from capital account surpluses.

China raised bank reserve requirements over 20 times between 2010-2011 to lock up excess liquidity resulting from its large trade surpluses.

3. Deposit Auctions and Repos

Central banks can issue their own securities and conduct repurchase agreements to borrow back excess liquidity injected due to capital inflows.

The Czech National Bank used deposit auctions between 2018-2019 to sterilize the koruna liquidity impact of Eurozone inflows.

4. FX Market Intervention

Direct buying and selling of foreign exchange by the central bank offsets the impact of exchange rate pressures on monetary base.

Frequent FX market intervention is done by the Hong Kong Monetary Authority to prevent HKD appreciation from capital inflows into the financial hub.

5. Prudential Financial Regulations

Tightening lending rules, foreign investment limits and capital buffer requirements for banks helps restrict credit growth and asset inflation from capital inflows.

Indonesia uses a variety of macroprudential measures along with market operations to contain the liquidity impact of foreign inflows.

Costs and Limitations of Sterilization for Central Banks

While sterilization helps insulate economies, it also imposes certain costs and constraints for central banks:

  • Sterilization is essentially borrowing high and lending low. Central banks lose money as the interest costs of mopping up inflows exceed returns on reserves.
  • Large-scale sterilization drains reserves and erodes central bank equity over time. This risks balance sheet insolvency.
  • The increased issuance of central bank securities could crowd out private borrowers as well as government debt.
  • Sterilizing perpetually against sustained one-way capital flows may not be feasible beyond a point. The threat of inflation or currency appreciation eventually reasserts itself.
  • It interferes with the monetary policy transmission mechanism and obscures market signals about excess liquidity conditions.
  • Extensive sterilization could encourage further destabilizing capital inflows in anticipation of such operations.

Therefore, central banks have to balance the costs and benefits of using sterilization to counter foreign exchange flows. It is typically used temporarily till the flows correct themselves or other policy adjustments kick in.

Real World Examples of Sterilization in Practice

China’s Sterilization Operations

China has a long history of sterilizing foreign exchange inflows arising from its persistent current account surplus against the US and other trading partners.

It has employed a mix of FX intervention, open market operations, higher reserve requirements, prudential regulations and controls on capital outflows at various times to neutralize the impact of dollar liquidity flooding its financial system.

China resisted pressure for rapid yuan appreciation for many years to support its export competitiveness. But continuous one-way intervention created risks of future devaluation and asset bubbles.

Bank of Japan’s Quantitative and Qualitative Easing (QQE)

To counter sustained deflationary pressures, the BOJ has implemented aggressive quantitative and qualitative monetary easing. This involves buying huge amounts of Japanese government bonds to inject yen liquidity into capital markets.

As a side effect, the resulting weak yen led to large capital outflows from Japan. But BOJ sterilized this using fixed rate deposit facilities to prevent contractionary effects on money supply. It enabled Japan to run consistent current account surpluses despite negative rates.

Swiss National Bank’s Euro Peg and Negative Rates

The Swiss central bank employed a combination of interventions to prevent runaway currency appreciation after the Eurozone crisis. It set a floor for the Swiss franc’s exchange rate against the euro to stabilize trade flows.

With capital flooding into the Swiss safe haven, SNB conducted massive outward sterilization operations. It imposed negative rates on bank deposits to curb destabilizing inflows attracted by higher yields.

Emerging Markets Facing Taper Tantrums

In 2013, the Fed’s announcement of future tapering of its quantitative easing program triggered pullout of funds by global investors from emerging markets. To offset the liquidity crunch, central banks used policy rates, FX intervention and sometimes capital controls.

But inward sterilization was of limited use due to insufficient reserves. Market pressures eventually forced countries like India and Indonesia to allow exchange rate depreciation to correct external imbalances.

Sterilization Philosophies of Major Central Banks

Central banks adapt their sterilization efforts to suit domestic macroeconomic conditions and priorities:

  • The US Fed typically does not intervene against exchange rate movements or capital flows due to its laissez-faire policy orientation.
  • The European Central Bank focuses on money supply and rate transmission for price stability. It sterilizes to maintain control over monetary conditions.
  • The Bank of Japan has embraced unsterilized FX intervention and QE as part of its reflationary Abenomics policy for higher growth and inflation.
  • The People’s Bank of China has shifted its stance over time from persistent sterilization to supporting greater exchange rate flexibility to rebalance growth drivers.
  • For small open economies like Singapore and Switzerland, exchange rate stability is a key priority. Their central banks actively sterilize flows to maintain currency pegs or alignments.

Conclusion

Sterilization forms an integral part of central banking operations today as economies cope with growing global capital flow volatility. It provides monetary authorities with some breathing room to sequence exchange rate and monetary adjustments.

With increasing financial openness, central banks are finding it harder to insulate domestic monetary conditions for extended periods through sterilization alone. Market forces eventually overwhelm administratively targeted interest rates and exchange rates, forcing a reset of policies.

Hence, sterilization is being used more tactically to smooth out destabilizing short-term capital flows. At the same time, central banks are deploying a combination of macroprudential regulations, foreign exchange intervention as well as market-determined interest rates to regain monetary control. Getting this policy mix right remains an ongoing challenge.