Sterilization refers to a monetary measure adopted by a central bank to counterbalance the impact of capital inflows and outflows on the money supply.
For example, if the exchange rate is Rs. 70 per USD and the Reserve Bank of India (RBI) aims to prevent the exchange rate from increasing, it sells dollars from its foreign exchange reserves.
This sale of dollars reduces the circulation of rupees and increases the supply of dollars, thereby preventing the value of the dollar from rising in comparison to the rupee. However, this action decreases the quantity of domestic currency in circulation, which may have undesired consequences such as an increase in interest rates. To offset or sterilize this effect, the central bank can simultaneously purchase domestic bonds, injecting domestic currency back into circulation.
Similarly, if a central bank buys foreign currency to maintain a low value of the domestic currency, it can sterilize this intervention by selling bonds and removing the introduced domestic currency from circulation.
In India, the RBI employs several mechanisms to stabilize the money supply against external shocks:
- Open Market Operations (OMO): The RBI uses OMO as the primary instrument of sterilization. It absorbs excess liquidity in the system by selling securities.
- Market Stabilisation Scheme (MSS): Under this scheme, the RBI issues Market Stabilisation Bonds (MSBs) to withdraw excess liquidity in the economy. The value of these bonds in rupees is treated as net RBI debt to the government. The proceeds from the MSS are held in a separate cash account and are used solely for the redemption of treasury bills or dated securities issued under the scheme.
- Balances of the Government of India with the RBI: As the RBI Act does not permit interest payments on government balances, these balances are invested in government securities held in the RBI’s portfolio, serving as a means of sterilization.
- Forex Swaps: Forex swaps enable the postponement of liquidity creation resulting from capital inflows, such as building up Forward Purchase Obligations for meeting the repayment of Resurgent India Bonds (RIBs).
- In addition to these mechanisms, the absorption or injection of liquidity through the Liquidity Adjustment Facility (LAF) and Cash Reserve Ratio (CRR) also possess sterilization capabilities. However, they are considered as last resort options when other measures have been exhausted.
The RBI’s prudent sterilization interventions in the forex market ensure that the growth of reserve money remains consistent with the requirements of the growing economy.
It also helps in aligning money market rates with the operating target of the monetary policy, regardless of the significant and persistent liquidity impact caused by forex interventions.
The effectiveness of such sterilization measures relies on continuous assessments of exchange market conditions, liquidity conditions, government securities market conditions, and forward market conditions.