Sterilized Intervention, Bank Credit, and Chinese Monetary Policy

Abstract

Foreign exchange intervention is widely used in emerging market economies as a stabilization tool to address the challenges from capital inflow surges. While existing studies suggest that sterilized foreign asset purchases by central banks can help dampen the expansionary effects of capital inflows on the domestic economy, we show that they can also have an unintended liquidity effect on domestic banks, running counter to the aims of the central banks. This is because the central bank securities issued as sterilization instruments can be used for liquidity management by commercial banks. Thus, sterilized foreign asset purchases increase the supply of liquidity management instruments. We investigate how the effectiveness of intervention can depend on the choice of sterilization instruments. The model is calibrated to the Chinese economy and used to evaluate the effectiveness of China's massive sterilized intervention in the early 2000s.

Keywords: sterilized intervention, liquidity management, bank credit, reserve requirement regulation, monetary policy, China

JEL Classification: E58, E51, F3