Sterilisation of Foreign Capital Inflows

Sterilisation is the RBI's action to neutralise the domestic liquidity created by its foreign-exchange intervention. When the RBI purchases foreign currency arising from capital inflows, it pays in rupees, increasing bank reserves and potentially expanding money and credit. It then uses liquidity-absorption instruments to limit this monetary expansion without reversing the reserve accumulation.

How foreign inflows create liquidity

Capital inflows do not automatically expand reserve money; the expansion occurs when the RBI purchases foreign currency from the market. This raises the RBI's net foreign assets and injects rupee liquidity into the banking system.

• Sterilisation offsets this injection by absorbing bank reserves through monetary operations.
• The RBI may sterilise the injection fully or partly, depending on its inflation, liquidity and monetary-policy objectives.

Main sterilisation instruments

• Through open market operations, the RBI sells government securities; buyers pay from bank balances, thereby withdrawing durable liquidity.
• Under the Market Stabilisation Scheme, the Union government issues Treasury Bills or dated securities specifically for liquidity absorption, and the proceeds remain impounded in a separate account with the RBI rather than financing expenditure.
• An increase in the Cash Reserve Ratio immobilises a larger share of banks' deposits with the RBI, although it affects the banking system broadly and raises intermediation costs.
• For temporary surpluses, the RBI can absorb funds through the Standing Deposit Facility or variable-rate reverse repo operations.

Effects and limitations

Sterilisation allows foreign-exchange reserves to rise while containing excess money growth, credit expansion and inflationary pressure. Its scale is constrained by the availability of securities, interest costs and the effect of prolonged absorption on domestic interest rates and bank lending.

• Market-based sterilisation may involve a carrying cost when the return on foreign reserves is lower than the cost of domestic sterilisation liabilities.
• Persistent and large inflows can therefore create a trade-off among exchange-rate management, monetary control and the cost of sterilisation.