What it means
When a central bank buys foreign currency to stop its own currency from rising, it pays with domestic money it creates. That adds to the cash in the banking system, which can push interest rates down and fuel inflation.
Sterilisation is the counter-move designed to prevent that side effect. The most common method is for the central bank to sell government bonds or its own securities to banks and investors.
Those buyers pay with domestic money, which drains cash out of the banking system. The result is that the foreign exchange purchase and the bond sale offset one another, leaving the money supply where it started.
Sterilisation has costs. The central bank now holds low-yielding foreign assets, while it has issued domestic debt on which it pays higher interest.
The difference is a running loss, sometimes called a quasi-fiscal cost, which ultimately falls on the government and taxpayers. It also has limits.
If the central bank sells enough bonds to push domestic interest rates up, it can draw more foreign money into the country, which works against the original aim. Economists debate how effective sterilised intervention is in the long run, since markets can overwhelm a central bank's resources.
For businesses, sterilisation matters because it affects exchange rates, interest rates and the cost of borrowing. Exporters, importers and companies with foreign debt follow the topic as a clue to central bank intentions.
A policy of persistent, heavily sterilised intervention can signal an effort to hold the currency down to support exports.
In practice
Real-world examples.
Example
A central bank in an export-driven economy buys foreign currency to stop its own currency from rising too fast. To avoid higher inflation, it issues $8,000,000,000 of bills to absorb the new cash. Exporters keep their price competitiveness while the money supply stays flat.
Example
A currency strategist at an investment bank estimates the cost of a central bank's sterilisation programme. She finds the bank's foreign reserves earn about 3% less than the interest it pays on its bills. She reports that the gap will cost the bank around $450,000,000 a year on $15,000,000,000 of operations. Her note warns clients that the bank may eventually tire of paying that bill.
Example
A manufacturer with large overseas sales follows central bank announcements closely. When the bank begins heavy sterilised purchases, the finance director concludes that the local currency is unlikely to strengthen soon. She delays buying a forward hedge and tracks the exchange rate monthly.
Formula
Calculation
Change in domestic money supply = foreign currency purchased in domestic terms - domestic bonds sold
Suppose a central bank buys foreign currency worth $5,000,000,000 in local money to slow its currency's rise. This adds $5,000,000,000 of new cash to the banking system. It then sells $5,000,000,000 of government bonds to banks, which removes the same amount of cash. The net change in the money supply is 5,000,000,000 - 5,000,000,000 = $0, so the intervention is fully sterilised. If the foreign assets earn 2% and the bonds cost 5%, the running cost is 5,000,000,000 x (5% - 2%) = $150,000,000 a year.Case study
Seen in the real world.
The Central Bank of Verdania is an illustrative, fictional institution facing strong inflows of foreign investment that pushed its currency sharply higher. Exporters complained that their goods were becoming too expensive abroad.
The bank bought $10,000,000,000 of foreign currency over six months, paying with newly created local money. To stop inflation rising, it sold the same amount of its own bills to local banks.
Interest rates stayed stable and the currency's rise slowed, but the bank's annual cost of holding the policy reached $300,000,000. The illustrative lesson is that sterilisation can protect domestic prices while intervening in the currency, but it is not free. The bank's governor told the legislature that the cost had to be weighed each year against the benefit to exporters.
Watch out
Common mistakes.
- Assuming that buying foreign currency has no effect on the money supply, when it creates new domestic money unless it is sterilised.
- Treating sterilisation as costless, when the interest paid on bonds usually exceeds the return on foreign assets.
- Believing sterilised intervention can hold a currency at any level, when large market flows can overwhelm a central bank.
Questions
People also ask.
What is the difference between sterilised and unsterilised intervention?
In sterilised intervention the central bank offsets the change in the money supply, while in unsterilised intervention it lets the money supply change.
Why do central banks sterilise?
To influence the exchange rate while protecting domestic goals such as controlling inflation and keeping interest rates stable.
Who pays for sterilisation?
The cost shows up in the central bank's profits and ultimately affects the government's finances, so taxpayers bear it indirectly.
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