Explain the concept of "sterilization" in the context of monetary approach to balance of payments.

The Monetary Approach to the Balance of Payments

The monetary approach, pioneered by Jacob Viner and further developed by Ronald McKinnon and Harry Johnson, fundamentally argues that the balance of payments is primarily a monetary phenomenon. Its core tenets include:

• Price Inflexibility: Prices, particularly in the short run, are assumed to be sticky and do not adjust rapidly to changes in demand and supply.
• Money Supply Dominance: Changes in the money supply are the primary determinant of nominal income and, consequently, the balance of payments.
• Fixed Exchange Rate Regime: The approach is most relevant under fixed or managed exchange rate regimes, where central bank intervention is more frequent.

Under this approach, a country with a rapidly expanding money supply will experience increased domestic demand, leading to higher imports and a deficit in the balance of payments. Conversely, a contractionary monetary policy will lead to lower demand and a surplus.

Defining Sterilization

Sterilization is a monetary policy technique employed by central banks to counteract the impact of foreign exchange intervention on the domestic money supply. When a central bank intervenes in the foreign exchange market to stabilize its currency (e.g., buying or selling foreign currency), it directly affects the domestic money supply.

For instance, if a central bank buys foreign currency to prevent its domestic currency from appreciating, it injects domestic currency into the economy, increasing the money supply. Sterilization involves offsetting this increase (or decrease) in the money supply through open market operations.

Mechanics of Sterilization

The process of sterilization typically involves the following steps:

1. Foreign Exchange Intervention: The central bank buys or sells foreign currency in the foreign exchange market.
2. Offsetting Domestic Operations: Simultaneously, the central bank undertakes open market operations in the domestic money market.
• If the central bank buys foreign currency (increasing domestic money supply), it sells government securities in the open market (decreasing domestic money supply).
• If the central bank sells foreign currency (decreasing domestic money supply), it buys government securities in the open market (increasing domestic money supply).

The goal is to maintain the desired level of domestic monetary aggregates despite the foreign exchange intervention. The effectiveness of sterilization depends on several factors, including the size of the intervention, the responsiveness of domestic money demand, and the credibility of the central bank.

Examples of Sterilization

• China (Early 2000s): China extensively used sterilization to manage the inflow of foreign exchange reserves resulting from its trade surplus. The People's Bank of China (PBOC) purchased large amounts of foreign currency to prevent the Renminbi from appreciating rapidly, and then issued central bank bills to absorb the excess liquidity created by these purchases.
• India (Post-2008 Financial Crisis): The Reserve Bank of India (RBI) employed sterilization techniques to manage capital inflows following the global financial crisis. RBI purchased US dollars to prevent excessive appreciation of the Indian Rupee and simultaneously sold government securities to neutralize the impact on the domestic money supply.

Limitations and Effectiveness of Sterilization

While sterilization can be a useful tool, it has limitations:

• Fiscal Costs: Persistent sterilization can lead to significant fiscal costs as the central bank accumulates large holdings of government securities.
• Signaling Effects: Frequent sterilization can signal a lack of commitment to exchange rate flexibility, potentially undermining confidence in the currency.
• Limited Effectiveness: Sterilization may become less effective if the scale of intervention is too large or if domestic money demand is highly sensitive to interest rate changes.
• Impact on Interest Rates: Large-scale sterilization can distort domestic interest rates, potentially affecting investment and economic growth.

The effectiveness of sterilization is also contingent on the degree of capital mobility. Under perfect capital mobility, sterilization is likely to be less effective as capital flows can easily offset the central bank's efforts.

Feature	Sterilization	Non-Sterilized Intervention
Impact on Money Supply	Neutralized	Directly affects
Domestic Interest Rates	Potentially distorted	Influenced by intervention
Fiscal Costs	High (due to security holdings)	Low
Effectiveness	Lower under high capital mobility	Higher under capital controls