International Liquidity Management: Sterilization Policy in Illiquid Financial Markets

During the booms that invariably precede crises in emerging economies, policy makers often struggle to limit capital flows and their expansionary consequences. The main policy tool for this task is sterilization --essentially a swap of international reserves for public bonds. However, there is an extensive debate on the effectiveness of this policy, with many arguing that it may be counterproductive once the (over-) reaction of the private sector is considered. But what forces account for the private sector's reaction remains largely unexplained. In this paper we provide a model to discuss these issues. We first demonstrate that policies to smooth expansions in anticipation of downturns can be Pareto improving in economies where domestic financial markets are underdeveloped. We then discuss the implementation of this policy via sterilization, outlining cases in which the policy succeeds and those in which it fails. Paradoxically the greatest risk of policy arises in situations where policy is most needed -- that is when financial markets are illiquid. Our mechanism is akin to the ``implicit bailout" problem, despite the fact that the central bank acts non-selectively and only intervenes through open markets; illiquidity replaces corruption and ineptitude. In addition to an appreciation of the currency and the emergence of a quasi-fiscal deficit, the private sector's reaction to sterilization may lead to an expansion rather than the wanted contraction in aggregate demand and a bias toward short term capital inflows.