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International Liquidity Management: Sterilization Policy in Illiquid Financial Markets

  • Ricardo J. Caballero
  • Arvind Krishnamurthy

During the booms that 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 remain largely unexplained. In this paper we provide a model to discuss these issues. We emphasize the international liquidity management aspect of sterilization over the traditional monetary one, a re-focus that seems warranted when the main concern is external crisis prevention. We first demonstrate that policies to smooth expansion in anticipation of downturns can be Pareto improving in economies where domestic financial markets are underdeveloped. We then discuss the implementation and effectiveness of this policy via sterilization. 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, although the central bank acts non-selectively and only intervenes through open markets in our model. 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 desired contraction in aggregate demand or nontradeables investment and to a bias toward short term capital inflows. The main insights extend to international liquidity management issues more generally.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7740.

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Date of creation: Jun 2000
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Handle: RePEc:nbr:nberwo:7740
Note: IFM EFG ME
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  1. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  2. Jeffrey A. Frankel., 1993. "Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?," Center for International and Development Economics Research (CIDER) Working Papers C93-024, University of California at Berkeley.
  3. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  4. Reinhart, Carmen & Montiel, Peter, 1999. "Do capital controls influence the volume and composition of capital flows? Evidence from the 1990s," MPRA Paper 13710, University Library of Munich, Germany.
  5. Jeremy A.Rogoff Bulow & Kenneth, 1986. "A Constant Recontracting Model of Sovereign Debt," University of Chicago - George G. Stigler Center for Study of Economy and State 43, Chicago - Center for Study of Economy and State.
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  8. Nicolas Magud & Carmen M. Reinhart, 2005. "Capital Controls: An Evaluation," University of Oregon Economics Department Working Papers 2005-19, University of Oregon Economics Department.
    • Nicolas Magud & Carmen M. Reinhart, 2007. "Capital Controls: An Evaluation," NBER Chapters, in: Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, pages 645-674 National Bureau of Economic Research, Inc.
  9. Guillermo A. Calvo, 1991. "The Perils of Sterilization," IMF Staff Papers, Palgrave Macmillan, vol. 38(4), pages 921-926, December.
  10. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  11. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  12. Kang, Jun-Koo & Stulz, Rene M., 1997. "Why is there a home bias? An analysis of foreign portfolio equity ownership in Japan," Journal of Financial Economics, Elsevier, vol. 46(1), pages 3-28, October.
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  14. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
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