RBI’s STERILISATION OPERATIONS

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 RBI’s STERILISATION OPERATIONS

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• Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the country’s money supply. That helps manage the exchange rate of local currency, as per policy. 
• Dollars flow into India – RBI’s action plan – INR value - Sterilisation
• Forex flows affect domestic monetary policy and exchange rate management. How such FDI and FPI flows impact depends on the kind of exchange rate regime followed.

1. In a fixed exchange rate regime, excess forex inflows, resulting from current and capital account surpluses, will have to be taken out, and into the forex reserves to maintain the desired exchange rate parity
2. In a fully floating exchange rate regime, the exchange rate would itself adjust according to demand and supply in foreign exchange market, and there would be no need for RBI to take such inflows into the forex reserves. Exchange rate may appreciate, and that itself may not restore equilibrium in the balance of payments (BoP)
3. In India, the exchange rate is largely market determined, but RBI intervenes to contain volatility (created by sudden inflows or outflows) and reduce risks 

• First, RBI checks if capital inflows are of permanent and sustainable or just temporary (so this is a day-to-day exchange rate and monetary management).
• RBI intervenes in the foreign exchange market through purchases of foreign exchange, and hence injects rupee liquidity into the system through the corresponding sales.
• RBI can also sell foreign exchange, and then domestic liquidity (rupees) will be absorbed. So an expansion or contraction of base money and money supply happens (may not be consistent with the prevailing monetary policy stance). So RBI needs to offsetting the impact of such interventions, partly or wholly.
• Techniques to offset - market based or non-market based approaches

1. Market based approach involves financial transactions between the central bank and the market, which leads to withdrawal or injection of liquidity. Aim is neutralisation of part or whole of the monetary impact of foreign inflows and this is "sterilisation"
2. Non-market based approach involves the use of quantitative barriers, rules or restrictions in market activity, which attempt to keep the potential injection of liquidity outside the domestic financial system. 

• Sterilisation process - 

1. Substitute foreign currency with domestic currency in case of excess capital inflows, and 
2. Intervene further in the bond or money market to substitute domestic currency so released out of the intervention in forex market with bonds or other eligible paper. 

• OMOs: Open market operations (OMO) involve sale of securities. So at time, one may be confused between normal liquidity mgmt. operations of RBI and sterilisation ops! 
• Other tools: Apart from exchange rate flexibility and forex market intervention, other policy responses to manage large capital inflows can be

1. Trade liberalisation: can increase imports leading to a higher trade and current account deficit and this would enable the economy to absorb the capital inflows. 
2. Investment Promotion: Absorption of capital flows for growth promoting purposes can be via greater investment in the economy. 
3. Liberalisation of the Capital Account: Liberalisation of outflows under the capital account can be considered while taking advantage of the excess forex inflows. But inflows grow if people get happier with liberalisation!
4. Management of External Debt: Pre-payment of external debt can be used to reduce the accretion of forex inflows. 
5. Management of Non-Debt Flows: Non-debt flows consist of foreign direct investment (FDI) and portfolio investments. Usually, FDI decisions are never used to restrict FDI flows. And to manipulate FPI will kill market sentiment.
6. Taxation of Inflows: Price based measures to restrict forex inflows could include the imposition of a “Tobin” type tax. However, such a tax has rarely been practised.
7. Use of Foreign Exchange Reserves: As reserves rise, it is suggested that such reserves can be used for "productive" domestic activities through onlending in foreign currencies to residents. If the reserves are used in such fashion domestically they are not then available as forex reserves. 

• One practical example: In India, the reserves increased from US $ 54 billion as at the end of March 2002 to US $ 95 billion by November 21, 2003. The liquidity impact of such large inflows was managed mainly through the day-to-day Liquidity Adjustment Facility (LAF). Liquidity absorption through LAF repos on a daily average basis, amounted to Rs.11,212 crore during 2002-03 and Rs.29,310 crore during 2003-04 (up to end-October). The LAF operations were supplemented by open market operations (OMO) of outright sales of government securities, amounting to Rs.52,716 crore during 2002-03 and Rs.35,733 crore during 2003-04 (up to end-October). Both these operations, however, require an adequate stock of government securities.  In addition to LAF and OMO, measures taken to deal with capital inflows have included building up of government balances with the Reserve Bank particularly through increase in the notified amounts of 91-day Treasury Bills, forex swaps, pre-payment of external debt, liberalisation of current and capital outflows and measures to restrict debt inflows.
• MSS: The Market Stabilisation Scheme (MSS) was introduced in April 2004 whereby the Government issues securities specifically for the purpose of sterilisation operations. The proceeds under the MSS were parked in a separate deposit account maintained by the Government with the Reserve Bank which was used only for the purpose of redemption and/or buyback of paper issued under the MSS. 

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