The Reserve Bank's action to neutralise the effect of its foreign-exchange operations on the domestic money supply, so that buying or selling foreign currency does not change the rupee liquidity in the system.
- When the RBI buys foreign currency (to stop the rupee appreciating), it releases rupees into the economy, which can fuel inflation; sterilisation soaks those rupees back.
- It is done mainly by selling government securities through open market operations, which pull rupees out of the banking system; see concept open market operations.
- The Market Stabilisation Scheme (MSS), launched in 2004, was a dedicated tool issuing special securities purely to absorb such surplus liquidity.
- The Cash Reserve Ratio can also be raised to lock up bank funds as part of sterilisation; see concept crr and slr.
- Sterilisation lets the RBI manage the exchange rate and foreign-exchange reserves without losing control of domestic money supply and inflation.
The concept (neutralising the money-supply impact of forex operations, via OMO and the Market Stabilisation Scheme of 2004) is a testable RBI-operations fact.
Sterilisation (cancelling the rupee-liquidity effect of forex intervention) is different from ordinary open market operations done only for monetary policy; here the OMO is used specifically to offset forex flows.
The RBI offsets the money-supply effect of its forex operations, mainly via OMO and the Market Stabilisation Scheme (2004).