Managing Capital Inflows Indirectly? On the Determinants of Monetary Sterilization with Reference to East Asia

• Published date: 01 May 2017
• DOI: http://doi.org/10.1111/roie.12265
• Date: 01 May 2017
• Author: Tony Cavoli

Managing Capital Inflows Indirectly? On the

Determinants of Monetary Sterilization with

Reference to East Asia

Tony Cavoli*

Abstract

This paper derivesa time-varying sterilization coefficient to examine thosefactors that determine the extent

to which central banks might engage in monetary sterilization. There appear to be good reasons to do so:

Sterilization neutralizes the monetary impact of reserve accumulation, which is an endogenous consequence

of sustained capitalinflows under some degree of management of exchange rates. A pooled sampleof Asian

economies incorporating Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand, for

1994–2012 is employed. We find that this method does help to directlyuncover the determinants of steriliza-

tion, and while capital inflows do not appear to influence the sterilization directly, there is substantial evi-

dence to suggest itdoes so indirectly—particularlythrough domestic interest rates.

1. Introduction

The monetary and financial systems and arrangements in emerging economies are still

for the most part centered around the existence of high capital mobility, managed

exchange rate regimes, and the resultant accumulation of foreign reserves (Cavoli and

Rajan, 2009). As such, it has long been held that the use of sterilized foreign exchange

intervention remains a viable policy choice for monetary authorities.

This paper, then, examines the extent and determinants of monetary sterilization

using a sample of six east and southeast Asian economies, Indonesia, Korea, Malaysia,

the Philippines, Singapore and Thailand for the period 1994–2012. These countries are

chosen because they are widely known to have engaged in sterilized intervention for a

very long time. Cavoli and Rajan (2006) report that five of the six counties reported

here (minus Singapore) possess very high levels of sterilization before the Asian Crisis.

Ouyang, Rajan and Willett (2008) also report high sterilization post-crisis. Specifically,

why might these countries engage in sterilization? First, authorities use sterilization

because they wish to neutralize the monetary impacts of reserve accumulation

(Villafuerte and Yap, 2015).

1

IMF (2014) report that, while not of the same magnitude

as larger economies in the region, the Asian economies samples in this paper possess a

substantial desire to continually accumulate reserves. This can be observed in Figure

1, where the annual percentage change in official reserve assets for each nation in this

study is reported. With the exception of 1997 and 2008—the periods corresponding to

the Asian and Global crises, respectively, the boxes appearing above the zero line

reveal that reserves are indeed accumulating for each country—significantly so for

2007 and 2010.

*Cavoli: UniSA Business School, University of South Australia, Adelaide, Australia. E-mail: tony.

cavoli@unisa.edu.au

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C2016 John Wiley & Sons Ltd

Review of International Economics, 25(2), 262–278, 2017

DOI:10.1111/roie.12265

A second, and related, justification for the use of sterilization is that the policy is

used to offset the reserve impacts of foreign capital inflows (Villafuerte and Yap,

2015; Kawai and Lamberte, 2008). High and sustained capital inflows have been pres-

ent in Asia since the early 1990’s (see IMF, 2011). More recently, from Figure 2, we

can see that the growth of capital inflows for each country in our sample has increased,

not only overall but in almost all of the components of capital inflow, viz FDI, portfo-

lio and bank based inflows.

2

Third (and also related), sterilization can be employed to regain control of the

domestic supply of money such that a regime of managed exchange rates can be main-

tained in the face of high capital mobility. We can see from Table 1 that there is evi-

dence of a degree of fixity among exchange rate regimes in the region—especially in

the case of Malaysia and Singapore. Indonesia and Thailand have managed regimes in

the middle part of the sample and Korea and the Philippines present a degree of flexi-

bility in their exchange rate arrangements.

3

There is extensive evidence to suggest that

Asian nations have employed, to varying extents, a degree of systematic management

of their exchange rates since a period of flexibility during the Asian crisis leading to

most re-employing de facto US dollar pegs in that period (Kawai and Pontines, 2014;

Cavoli and Rajan, 2009). Further, the evidence among certain measures of de facto

exchange rate systems for the countries sampled suggests that they actually exhibited

greater fixity (especially to the USD) than presented under the IMF definitions (see

Kawai and Pontines, 2014). As such, the presence of managed exchange rate mecha-

nisms imply the possibility of sterilized intervention. McCauley (2006) states that steri-

lization is part of the suite of macro-financial policies designed in part for the purposes

of exchange rate stabilization. Kawai and Lamberte (2008) provide that such interven-

tion is employed to soak up excess liquidity brought about by foreign exchange inter-

ventions for Korea.

4

For the most part, the rationale for employing sterilization is the broadly same for

each of these countries. Each have accumulated substantial holdings of foreign

reserves, and its associated monetary impact, in the face of managed currency regimes

and high capital inflow. But which of these variables (reserves, capital inflows,

Figure 1. Official Reserve Assets (yearly % change—Excl Gold) 2005–12 [Color fig-

ure can be viewed at wileyonlinelibrary.com]

Source: Author calculations using World Development Indicators.

DETERMINANTS OF MONETARY STERILIZATION 263

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C2016 John Wiley & Sons Ltd