The term sterilization is used in international economics and macroeconomics to describe the actions a central bank undertakes in order to neutralize the effects of central bank interventions in the foreign exchange market on the supply of domestic currency in the economy. Sterilization usually takes the form of an open market operation, in which a central bank sells or purchases government bonds on an open market in the amount it purchases or sells foreign currency on the foreign exchange market, so that the amount of domestic currency in circulation remains unchanged.
Suppose for example that it takes $1.35 to purchase €1; that is, it takes 1.35 American dollars to purchase 1 euro (the currency of the European Union). Suppose further that the Federal Reserve System (the United States’ central bank) wishes to keep the exchange rate from rising from its current level to say $1.50 for €1. To accomplish this task the American central bank must sell euros (foreign exchange) out of its reserves. Since the euros will be purchased with dollars, the supply of dollars in circulation will decrease and the supply of euros in circulation will increase. Thus the value of the euro will not rise relative to the dollar. But this action reduces the amount of domestic currency in circulation in the United States, which might not be desirable. For example interest rates might rise. In order to counteract this effect, the central bank may simultaneously purchase domestic (American) bonds in order to put domestic currency back in circulation. Similarly if a central bank is buying foreign currency to keep the value of domestic currency low, it can sterilize such intervention by selling bonds and removing from circulation domestic currency that was introduced by such foreign exchange market intervention.
If an intervention in a foreign exchange market is accompanied by a sterilization operation, it is called a sterilized intervention. International economics theory states that a sterilized intervention has occurred when: (1) international assets are perfect substitutes; (2) there is full capital mobility; and (3) the uncovered interest parity holds (that is, if one tries to make money by borrowing at a low interest rate in one currency and investing at a high interest rate in another currency, any gains will be offset by the change in the exchange rate). However if international assets are not perfect substitutes, or there are barriers to the flows of capital across borders, sterilized intervention can be effective in maintaining a certain level of exchange rate while minimizing the effect of interventions on the supply of domestic currency. In his 2003 article “Is Official Foreign Exchange Intervention Effective?” Michael Hutchison argued that in practice sterilized interventions have been effective.
One recent example of a central bank actively engaged in sterilized interventions is the People’s Bank of China, China’s central bank. In order to prevent the value of RMB, Chinese currency, from rising too fast against the U.S. dollar in the early 2000s, the People’s Bank of China was actively purchasing dollars while at the same time issuing its own central bank bills. As a result the effect of foreign exchange interventions on the supply of domestic currency was neutralized, and the People’s Bank of China accumulated foreign reserves, while Chinese commercial banks accumulated their holdings of central bank bills, claims on the People’s Bank of China. The reason sterilized interventions were effective in China is limited capital mobility in and out of China, as a result of which Chinese and foreign assets are not perfectly substitutable.
Less frequently the term sterilization is used to describe the actions a central bank might take in order to reduce the effects of international capital inflows on the supply of domestic currency in the country. This type of sterilization was important during the lending boom of the 1990s when many emerging markets experienced a surge in international capital inflows, which was accompanied by the rise in domestic money supply and therefore inflation. In his 1997 article “Sterilizing Capital Flows” Jang-Yung Lee provided a detailed discussion of the sterilization of international capital inflows.
SEE ALSO Capital Controls; Capital Flight; Economics, International; Euro, The; Federal Reserve System, U.S.; Macroeconomics; Policy, Monetary
Hutchison, Michael. 2003. Is Official Foreign Exchange Intervention Effective? Federal Reserve Bank of San Francisco Economic Letter, July 18. http://www.frbsf.org/publications/economics/letter/2003/el2003-20.html.
Lee, Jang-Yung, 1997. Sterilizing Capital Flows. International Monetary Fund Economic Issues (7). http://www.imf.org/external/pubs/ft/ISSUES7/issue7.pdf.