Previous Year Question
Which one of the following activities of the Reserve Bank of India is considered to be part of ‘sterilisation’?
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
Correct Answer: A
Detailed Solution
Sterilisation is the process through which the RBI neutralises the effect of its foreign-exchange-market intervention on domestic money supply and banking-system liquidity.
Suppose large capital inflows create appreciation pressure on the rupee. The RBI may purchase dollars and release rupees into the domestic financial system. This increases rupee liquidity. If this additional liquidity remains in the system, it may expand money supply and generate inflationary pressure.
To neutralise this effect, the RBI may sell government securities through Open Market Operations. Banks and other market participants pay rupees to purchase these securities. Consequently, excess liquidity moves from the banking system to the RBI. Thus, the sale of government securities offsets the liquidity created by the RBI’s purchase of foreign currency.
The reverse can also occur. When the RBI sells dollars, it receives rupees and absorbs domestic liquidity. If required, it may purchase government securities to restore the desired level of liquidity.
RBI documents identify Open Market Operations, changes in reserve requirements, the Liquidity Adjustment Facility and the Market Stabilisation Scheme as instruments that may be employed for sterilisation. Among the given alternatives, therefore, conducting Open Market Operations is the correct answer.