Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
refers to the actions taken by a country's central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
to counter the effects on the money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
caused by a balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
surplus or deficit.
This can involve open market operations undertaken by the CB whose aim is to neutralize the impact of associated foreign exchange operations. The opposite is unsterilized intervention, where monetary authorities have not insulated their country's domestic money supply and internal balance against foreign exchange intervention.
Most often sterilization
is used in the context of a central bank which takes actions to negate potentially harmful impacts of capital inflows
The current and capital accounts make up a country's balance of payment . Together these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals...
– such as currency appreciation
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
– both of which can cause loss of export competitiveness. More generally it may refer to any form of monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
which seeks to leave the domestic money supply unchanged in the face of external shocks or other changes, including capital outflows.
In the second half of the 20th century, sterilization
was sometimes associated with efforts by monetary authorities to defend the value of their currency. In the 1930s and in the 21st century, sterilisation has most commonly been associated with efforts by nations with a balance of payments surplus to prevent currency appreciation.
A sterilized intervention to prevent currency depreciation
Assume that a country's currency is depreciating
Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears...
. To prevent this the country's central bank may decide to intervene in the foreign exchange market. To prop up the value of the nation's currency the CB may resort to creating artificial demand for its currency. It can do this by using some of its foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
to buy local currency. The resulting demand stops the currency's depreciation but also acts to reduce the domestic money supply
in two ways. First the bank is directly removing some of the nation's currency from circulation as it buys it up. Secondly the intervention can create or worsen a current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
deficit due to the propped-up exchange rate being more favorable for importers than for exporters. This deficit sends money out of the economy, further decreasing liquidity.
The resultant lowering of the money supply will likely have a deflationary effect which can be undesirable especially if the country already has substantial unemployment. To offset the effect on the money supply, the CB may sterilise its foreign exchange intervention. It can do this by engageing in open market operations that supply liquidity into the system, by buying financial assets such as local-currency-denominated bonds, using local currency as payment.
A sterilized intervention against depreciation can only be effective in the medium term if the underlying cause behind the currency's loss of value can be addressed. If the cause was a speculative attack
A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...
based on political uncertainty this can potentially be resolved. In practice, the cause driving sterilised interventions in the late 20th century was often that a high money supply had meant local interest rates were lower than they were internationally, creating the conditions for a carry trade. This involves market participants having an earner by borrowing domestically and lending internationally at a higher rate of interest, which as a side effect exerts a downwards pressure on the nation's currency. Because after a sterilised intervention the money supply remains unchanged at its high level, the locally available interest rates can still be relatively low. So the carry trade continues and if it still wants to prevent depreciation the CB has to intervene again. This can only go on so long before the bank runs out of foreign currency reserves.
A sterilized intervention to prevent currency appreciation
A central bank can intervene on the foreign exchange markets to prevent currency appreciation by selling its own currency for foreign currency-denominated assets, thereby building up its foreign reserves as a happy side effect. However, because the CB is creating or at least releasing more of its currency into circulation, this will expand the money supply – money spent buying foreign assets initially goes to other countries, but then soon finds it way back into the domestic economy as payment for exports. The expansion of the money supply can cause inflation, which can erode a nation's export competitiveness just as much as currency appreciation would.
The classic way to sterilize the inflationary effect of the extra money flowing into the domestic base is for the central bank to use open market operations where it sells bonds domestically, thereby soaking up new cash that would otherwise circulate around the home economy. A variety of other measures are sometimes used.
A central bank normally makes a small loss from its overall sterilization
operations, as the interest it earns from buying foreign assets to prevent appreciation is usually less than what it has to pay out on the bonds it issues domestically to check inflation.
Over the first few years of the 21st century, China was able to make a good yearly profit on its sterilization operations, estimated at close to $60 billion a year. By about 2008, however, the country began to make a loss, estimated at about $40 billion by 2010. Other countries also found sterilization more costly after 2008, relating to expansionary monetary policies adopted by advanced economies hit by the financial crisis, most especially the United States. which meant relatively low interest rates were available for their foreign assets.
The increased losses from classic open market operations since 2008 have seen China increasingly use an alternative method for preventing monetary expansion - the raising of the Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
for its larger banks.
In contrast to interventions against currency depreciation, there is no inherent limit on interventions aimed at preventing appreciation. If a central bank runs out of domestic currency to buy foreign reserves, it can always print more. There can be political pressure from other nations if they feel a country is giving its exporters too much of an advantage, at the extreme this can escalate to currency war
Currency war, also known as competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. As the price to buy a particular currency falls, so to does the real price of exports from the...
. There can also be political pressure domestically if commentators feel too big a loss is being made by the sterilisation operations.
Sterilization under a gold standard
With a gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...
such as the one that was widely in effect from about 1871–1914, exchange rates are fixed so generally there is no currency appreciation or depreciation (except within a very narrow band, relating to the cost to ship gold between countries). So if one country enjoys a trade surplus, this results in it enjoying a net inflow of gold from its deficit trading partners. The automatic balancing mechanism is then for the surplus nation's money supply to be expanded by the inflowing gold. This will tend to lead to inflation or at least to the nations citizens having more money to spend on imports, and hence the surplus will be corrected.
To prevent the expansion of the money supply, central banks can effectively build up hoards of gold by employing a variety of measures such as increasing the amount of gold that banks need to store in their vaults for each unit of paper currency in circulation. Sterilization was used by the US and France in the 1920s and 1930s, initially with some success as they built up huge hoards of gold, but by the early 1930s it had contributed to a collapse in international trade that was harmful for the global economy and especially for the surplus nations.