Sterilization

Sterilization is a market intervention undertaken by central banks to prevent inflows and outflows of capital from influencing domestic money stocks. When central banks buy and sell financial assets, whether foreign currencies or domestic bonds, domestic money stocks are affected. If a central bank purchases a government bond, the domestic money stock will increase by some multiple of the amount of the purchase. The central bank purchases the bond with newly created funds. If the central bank sells a government bond, the domestic money stock contracts.

Buying and selling government bonds is the most important method central banks have for regulating domestic money stocks. The procedure is called “open market operations.” When a central bank purchases foreign currency in foreign exchange markets, it again pays for the foreign exchange with newly created funds and the domestic money stock increases. It will also have an impact on the money stock in the home country of the foreign exchange that is purchased. That is, if the United States Federal Reserve Bank purchases one million British pounds, the U.S. money stock increases and the United Kingdom’s money stock declines. Both the United States and the United Kingdom could undertake open market operations to cancel out the effects of the foreign exchange transaction on domestic money stocks. It is called “sterilization” when central banks undertake offsetting open market operations to cancel the domestic money stock effects of foreign exchange intervention. Since a central bank purchase of foreign exchange increases domestic money stocks and a central bank sale of a government bond decreases domestic money stocks, the central bank can sterilize the money stock effects of the foreign exchange purchase by selling government bonds.

Issues of sterilization often come up in discussions of economic stabilization in fast-growing emerging markets. Before a U.S. investor can invest in South Korea, the U.S. investor must first use dollars to purchase South Korean currency. If there is a strong inflow of foreign capital into South Korea, foreign investors will be buying large amounts of South Korean currency, bidding up the price or exchange rate of South Korean currency in foreign exchange markets. South Korea’s central bank has a choice of selling South Korean currency for foreign currency, or letting South Korea’s currency appreciate in foreign exchange markets. Letting South Korea’s currency appreciate will cause the price of South Korea’s exports to increase in foreign markets, possibly dampening South Korea’s growth.

If South Korea’s central bank meets the stronger demand for South Korean currency by selling South Korean currency for foreign currency, then South Korea’s money supply may grow at an inflationary rate. The central bank of South Korea can sterilize the effects of the capital inflows by selling South Korea government bonds, and taking the proceeds out of circulation, cancelling the money supply growth driven by the purchase of foreign currency. Put differently, a nearly simultaneous purchase of foreign currency and sale of government bonds has a zero effect on South Korea’s stock of money. Some emerging economies have had difficulty making this policy work because selling government bonds tends to push up domestic interest rates, which attracts even more foreign capital.

Some observers claim that aggressive sterilization contributed to Japan’s episode of deflation. In 2004, Alan Greenspan described Japan’s currency market interventions as “awesome” (Makin, March 2004). Japan was purchasing U.S. dollars in foreign exchange markets to strengthen the value of the dollar. A strong dollar lowers the cost of Japanese goods to U.S. consumers. At the time, Japan was experiencing deflation, giving Japan reason to welcome the inflationary effects of dollar purchases with yen. Instead, Japan sterilized its foreign exchange intervention by withdrawing yen from domestic money markets.