Q. 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’

Sterilization

• Sterilization is an action taken by the Central Bank (such as RBI in India) to counterbalance the effects of foreign exchange interventions on domestic money supply and inflation. It is done to neutralize the impact of inflows or outflows of foreign exchange reserves on the domestic monetary system.
  • The sterilization process is used to manipulate the value of one domestic currency relative to another and is initiated in the foreign exchange market.
  • Example:
    • A U.S. investor looking to invest in India must use dollars to purchase rupees. If a lot of U.S. investors start buying up rupees, the rupee exchange rate will increase.
    • At this point, the Indian central bank can either let the fluctuation continue, which can drive up the price of Indian exports, or it can buy foreign currency with its reserves in order to drive down the exchange rate.
    • If the central bank decides to buy foreign currency, it can attempt to offset the increase of rupees in the market by selling rupee-denominated government bonds.
• Open Market Operations (OMOs) are one of the tools used by the RBI for sterilization. OMOs are the purchase or sale of government securities by the Central Bank in the open market in order to regulate the money supply in the economy. 
  • When the RBI buys government securities, it injects liquidity into the economy, while when it sells these securities, it absorbs liquidity from the economy.
• Through OMOs, the RBI can either inject or drain liquidity from the banking system in order to maintain price stability and promote economic growth. This is done to neutralize the inflationary or deflationary impact of foreign exchange interventions on the domestic economy.