UPSC Prelims 2023 Q24: RBI Sterilization — Explained
Which one of the following activities of the Reserve Bank of India is considered to be part of 'sterilization'?
- Conducting 'Open Market Operations'
- Oversight of settlement and payment systems
- Debt and cash management for the Central and State Governments
- Regulating the functions of Non-banking Financial Institutions
Answer: (a) Conducting 'Open Market Operations'
Statement-wise explanation
- a: correct — Sterilization means cancelling out the effect that the RBI's foreign-exchange operations have on rupee money supply. When the RBI buys dollars to absorb large capital inflows, it releases rupees into the banks. It then sells government securities through Open Market Operations (OMOs) to take those rupees back out. RBI documents name OMO as the main sterilization instrument. The Market Stabilisation Scheme (MSS), set up by a Government–RBI MoU of 25 March 2004, was added because the RBI's own stock of securities was not enough for this job.
- b: incorrect — Overseeing settlement and payment systems is the RBI's job as regulator under the Payment and Settlement Systems Act, 2007, working through its Payments Regulatory Board. This work keeps payment systems like RTGS, NEFT and UPI safe and efficient. It has no role in neutralising the money that forex operations create.
- c: incorrect — Under the RBI Act, 1934, the RBI is banker and debt manager to the Central Government, and to State Governments by agreement. It floats their loans, pays interest and repayments, and gives them short-term cash support. This is a service to governments. It is not a tool for absorbing liquidity created by forex intervention.
- d: incorrect — The RBI registers, regulates and supervises Non-Banking Financial Companies under Chapters IIIB and IIIC of the RBI Act, 1934. This is a prudential job meant to keep the financial system sound. It has nothing to do with the money-supply effect of buying foreign exchange.
How to eliminate
You can solve this with one idea. Sterilization is a monetary operation: it adds or removes rupee liquidity to cancel the effect of forex flows. So look for the only option that changes the amount of money in the banking system. Payment-system oversight and NBFC regulation are regulatory and supervisory jobs, which removes two options at once. Debt and cash management for governments is the trap. It involves government securities, just like OMOs. But managing debt means raising money for the government. It is not about controlling the money supply. Remember this pair: sterilization is done with OMOs, the MSS, and liquidity absorption through the LAF, such as reverse repo or the SDF.
Know more
Sterilization is how a central bank cancels out the effect of its forex operations on the domestic money supply.
Why it is needed: Suppose large foreign inflows come in through FDI, FPI or remittances. The rupee rises. To slow that rise, the RBI buys dollars and pays for them in rupees. Those extra rupees in the banks can push up inflation. To 'sterilize' them, the RBI absorbs the same amount through another channel. Its forex reserves grow, but the money base stays about the same.
The reverse also happens. When the RBI sells dollars to defend the rupee, rupee liquidity shrinks. It may then buy G-secs to put liquidity back.
| Instrument | How it absorbs liquidity | Nature |
|---|---|---|
| OMO sale of G-secs | Banks pay rupees to the RBI for securities | Durable, outright |
| Market Stabilisation Scheme (2004) | Government issues T-bills/dated securities; proceeds are locked in a separate MSS account | Durable, meant only for sterilization |
| Reverse repo / VRRR / SDF under the LAF | Banks park surplus funds with the RBI | Short-term |
| CRR increase | Banks must keep more cash with the RBI | Blunt, wide-reaching |
| Forex swaps | Buy-sell swaps temporarily adjust rupee liquidity | Temporary |
Key points:
- Sterilization has a cost. The RBI earns little on its forex reserves but pays market rates on the securities it uses to absorb rupees.
- The MSS came about because the RBI's own stock of G-secs was running out during heavy inflows in 2003–04. A Government–RBI MoU was signed on 25 March 2004.
- 'Unsterilized' intervention leaves the extra liquidity in the system on purpose.
- Do not confuse sterilization with the RBI's other roles: issuer of currency, banker to government, regulator of banks and NBFCs, overseer of payment systems, and manager of foreign exchange.
NCERT Concepts to Revise
- Open market operations: The question asks whether OMOs are a sterilization tool, so know exactly what an OMO does to bank liquidity.
- Outright open market operations: Outright OMOs are permanent changes to liquidity, which matters when weighing a long-lasting effect of forex intervention.
- Monetary policy: Sterilization is about the money supply, so knowing what monetary policy covers helps sort the four RBI activities listed.
- Liquidity Adjustment Facility: Reverse repo and SDF windows under the LAF also absorb surplus liquidity, so they belong in any list of sterilization tools.
- Contractionary monetary policy: Sterilizing a forex inflow means pulling money out of the banks, which is the same direction as contractionary policy.