Sterilized vs Unsterilized Intervention
When a central bank buys or sells its own currency to move the exchange rate, it can either let that trade change the domestic money supply, or quietly cancel out the side effect with an offsetting trade — the difference between unsterilized and sterilized intervention.
Prerequisites: Central Bank FX Intervention
A central bank that wants a weaker currency can simply print local currency and use it to buy foreign currency in the market. That single trade does two things at once: it pushes the exchange rate the direction the bank wants, and it also expands the domestic money supply, since new local currency was just created to pay for the trade. Often the central bank does not want that second effect — maybe it is fighting inflation and does not want more local currency sloshing around even while it weakens the exchange rate. The fix is a second trade that undoes the money-supply effect while keeping the FX trade in place. That two-step process is sterilization.
Unsterilized intervention lets an FX trade change the domestic money supply along with the exchange rate. Sterilized intervention adds a second, offsetting domestic trade — usually selling government bonds — so the money supply ends up unchanged while the exchange-rate effect remains.
The two-step mechanism
Say a central bank sells its own currency to buy dollars, weakening the currency and increasing its reserves. That currency sale, left alone, increases the amount of local currency circulating in the banking system — commercial banks now hold more of it as reserves, which can push domestic interest rates down and fuel more lending. To sterilize, the central bank immediately sells government bonds to the same banks, soaking the extra local currency back out of the system. The exchange-rate intervention stands; the domestic money-supply and interest-rate impact is reversed.
Worked example
A central bank wants to slow a rapid currency appreciation without loosening domestic monetary conditions, since inflation is already running hot. It buys $2 billion of foreign currency by creating and selling 2 billion units of local currency, which on its own would add roughly 2 billion units of extra bank reserves to the system. The same week, it sells 2 billion units of government bonds to domestic banks, pulling that same 2 billion back out of circulation. Bank reserves and short-term interest rates end the week essentially where they started; the central bank's foreign reserves are $2 billion higher, and the currency, all else equal, is a bit weaker than it would have been without the intervention.
What this means in practice
Sterilization is not free. Selling bonds to soak up the injected currency means the central bank is now paying (or receiving) interest on a bigger balance sheet, and if it is defending a currency for a long stretch, the bond sales needed to keep sterilizing day after day can start moving domestic bond yields and become a fiscal cost in their own right. Emerging-market central banks running persistent sterilized intervention are effectively financing their entire FX reserve stockpile with a rolling stream of domestic bond issuance.
Sterilized intervention changes the exchange rate mainly through a "signaling" or portfolio-balance channel — the fact that the central bank is willing to act — rather than through the classic textbook channel of a genuinely tighter or looser money supply, since that supply effect has just been cancelled out. That is why sterilized intervention is often found to have smaller and less durable effects on the exchange rate than unsterilized intervention of the same size.
Related concepts
Practice in interviews
Further reading
- BIS, 'Foreign Exchange Market Intervention in Emerging Markets: Motives, Techniques and Implications'