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Impacts Of China's Sterilization Intervention

Sterilized intervention is a technique used by central bank to offset the effects of foreign exchange transaction on the domestic monetary base by using major monetary tools. When there is an influx of capital, it will push up the demand for domestic currency and the currency will appreciate. Central bank then needs to intervene to reduce volatility and prevent an appreciation which will deteriorate export sector. As a result of that, higher money base or excess liquidity will happen and bring about an overheating economy and inflation problem. These are severe problems, particularly in export-led and developing countries. To prevent or ease the problems, a so-called “sterilized intervention” policy has been widely employed by developing countries’ central bank.
Regardless of the forms of a massive capital inflow - FDI, exports, or portfolio investment, central bank can make use of direct intervention and/or indirect intervention to cope with currency appreciation pressures. Three major tools available for central banks in conducting sterilized intervention are open market operation (OMO), banks’ reserve requirement, and discount rate. Once the People’s Bank of China (PBC), China’s central bank, step into exchange market in order to prevent appreciation, what is conducted next is selling domestic assets which are government bonds or its bills, aiming at reducing inflation stress. Other tools available for PBC are raising lending rates of the bank and reserve requirement ratio, etc.
Commonly known, China is an export-led economy. In early 2000s, a massive FDI flooded into Chinese economy. Especially after China had officially joined WTO in the end of 2001, FDI further surged in the country, from US$84.8 bn of contracted FDI in 2002 to US$115.1 bn in 2003. Not just only an inflow of foreign funds but also a rapid growth of export sector that built up the demand for renminbi (RMB) and put a pressure on appreciation of RMB. Obviously China did not let that happen...