Foreign Capital Inflows and Monetary Sterilization in Papua New Guinea

The central bank uses sterilization policy to mitigate the monetary effects of foreign capital inflows in PNG. The effectiveness of the policy depends not only on the conduct of open market operations, but also on the raising of cash reserve requirement. Thus, this paper estimates the sterilization and non-sterilization coefficients by using the monetary policy reaction and money supply functions. The empirical analysis uses quarterly data from March 1998 to December 2020 under the 2SLS framework. The estimated coefficients indicate that the central bank highly sterilizes the monetary effects of foreign capital inflows. However, the intensity of sterilization is not perfect through the implementation of both monetary policy instruments. Hence, the unsterilized reserves positively influence the monetary base and money supply in the domestic economy. Furthermore, the findings establish that the open market operations are more effective than cash reserve requirement regarding the success of monetary sterilization in PNG. The study suggests that in order to effectively manage the monetary effects of capital inflows, the central bank may consider other policy option such as fiscal tightening and capital controls.