Defending a peg with negative real rates: is sterilization actually tightening?
A small open economy pegs its currency to the US dollar and permits free capital mobility. Twelve-month CPI inflation is 9.4%, against 2.8% in the anchor country. Bank credit is growing 23% year on year, the policy rate is 6.5%, and the US policy rate is 5.25%. Over the past six months the central bank has bought $4.1 billion of foreign exchange to hold the peg, injecting domestic currency; to mop this up it has sold $3.6 billion of its own 91-day bills at 7.4%. Reserves now cover 5.2 months of imports. The fiscal deficit is 4.8% of GDP, and the government has ruled out tax rises before next year's election. An IMF mission recommends 'raising the policy rate to at least 11%', while the finance ministry argues that sterilization is already doing the job because bill sales have drained the liquidity created by intervention. Both sides agree the peg must hold through the election.
1. Using the impossible trinity and the central bank balance sheet, assess the finance ministry's claim that sterilization is delivering a tightening.
Read the worked answer
The trinity constraint. With a peg and open capital markets, the domestic interest rate cannot be set independently of the anchor rate plus expected depreciation and a risk premium. A bill rate of 7.4% against 5.25% abroad is not evidence of tight money; it is roughly the price of a devaluation risk premium plus a small term premium. If the market believed the peg fully, arbitrage would push the bill rate towards 5.25%. The gap is a warning signal, not a policy success.
Balance sheet mechanics. FX purchases of $4.1bn expand reserve money; selling $3.6bn of central bank bills withdraws most of it. The net effect on liquidity is small, but the composition changes: the central bank swaps non-interest-bearing currency for interest-bearing liabilities. That does not raise the cost of credit for banks if they can rediscount or if they hold the bills as liquid assets; it mainly transfers income to bill holders.
The real rate test. With inflation at 9.4% and a 6.5% policy rate, the ex-ante real rate is about −2.9%. Money is cheap in real terms, which is consistent with 23% credit growth, not with tightening. Sterilization mops up the symptom (reserve money) while the credit boom is driven by bank lending funded domestically.
Conclusion. The ministry confuses draining liquidity with tightening conditions. With the trinity binding and real rates negative, bill sales cannot deliver a durable tightening; they buy time and cost money.
2. Quantify the quasi-fiscal cost of the sterilization operation and explain who ultimately bears it. Note any offsetting valuation effects.
Read the worked answer
The carry calculation. The central bank holds roughly $3.6bn of additional reserves (invested in low-risk dollar assets yielding about 5.25%) and has issued $3.6bn of domestic bills at 7.4%. The annual carry is 3.6bn × (7.4% − 5.25%) = 3.6bn × 2.15% ≈ $77.4 million per year. Reserves are larger than the bills ($4.1bn against $3.6bn), so part of the intervention is unsterilized and also expands the monetary base.
Valuation effects. If reserves are dollar-denominated and the bills are in domestic currency, a depreciation raises the domestic-currency value of reserves and produces a valuation gain that can swamp the carry; an appreciation produces a loss. The carry is therefore a flow cost conditional on the exchange rate, not a full measure of the balance sheet risk.
Incidence. The loss lands on the central bank's profit and hence on its remittance to the treasury - taxpayers bear it - and partly on depositors and borrowers through the wider interest spread needed to fund the bills. If reserve requirements are used instead, the cost is hidden as an implicit tax on banks and their depositors.
Relevance. $77m is small relative to GDP in most economies of this size, but it grows if the spread widens or if reserves earn less than assumed. The larger cost is not the carry: it is the credit boom and the loss of competitiveness from 6.6 points of inflation differential accumulating as real appreciation.
3. Recommend a policy package to the authorities and state the main risk of your recommendation, with a sequencing argument.
Read the worked answer
Diagnosis. The economy faces a trilemma, a fiscal impulse (deficit 4.8%), negative real rates, and a real appreciation from the inflation differential. Raising the policy rate alone to 11%, as the IMF suggests, would attract more inflows and require more sterilization, worsening the carry and the balance sheet - it treats the symptom.
Recommended package. (1) Fiscal consolidation first: a credible path from 4.8% to about 3% of GDP, front-loaded on transfers and capital spending with low multipliers, because fiscal tightening is the only instrument that reduces absorption without attracting capital. (2) Macroprudential tightening aimed at the 23% credit growth: countercyclical capital buffers, tighter loan-to-value limits, and a credit-growth cap, which slow lending without raising the interest rate that attracts inflows. (3) A one-off, well-communicated widening of the band or a modest appreciation of 5–8% to restore competitiveness and break the one-way bet, enacted while reserves cover 5.2 months of imports. (4) Move the policy rate to a small positive real level, but only after the band adjustment, to avoid inviting a speculative inflow at a fixed parity.
Main risk. Announcing the band change can trigger the outflow it is meant to pre-empt: domestic residents and banks may convert before the new parity is established. This is why sequencing matters - fiscal credibility and reserve buffers first, parity adjustment second, rate decision third, with a communication plan prepared in advance. A sudden stop would force a choice between reserve drawdown and an unplanned float.