Central banks intervene in the foreign exchange market to control the value of their currency. These interventions affect two main components of the monetary base: Net Foreign Assets (NFA) and Net Domestic Assets (NDA). The total reserve money (RM) is the sum of NFA and NDA.
In an unsterilized intervention, NRB buys or sells foreign currency without offsetting the impact on the domestic money supply. For example, when NRB buys US dollars due to high remittance inflows, the NFA increases. Since the NRB pays Nepali Rupees to the market, the overall reserve money increases while NDA remains unchanged.
This increase in money supply can lead to inflation and lower interest rates, making monetary policy expansionary. The domestic economy receives more liquidity, which can stimulate demand but also risk overheating.
On the other hand, a sterilized intervention involves the NRB offsetting the effects of foreign exchange operations on the money supply. If NRB buys US dollars, it increases NFA, but it simultaneously sells government bonds or other securities to reduce NDA by the same amount.
This action keeps the reserve money stable. As a result, sterilized intervention stabilizes the exchange rate without increasing inflation or affecting interest rates, maintaining monetary neutrality.
In Nepal, the NRB often uses sterilized interventions to manage large inflows of remittances. This helps maintain monetary stability while keeping the exchange rate peg to the Indian Rupee intact.
In summary,
Central banks intervene in the foreign exchange market to manage currency value. These interventions affect:
- NFA: Net Foreign Assets
- NDA: Net Domestic Assets
The monetary base (Reserve Money) is defined as:
Reserve Money (RM) = NFA + NDA
Unsterilized Intervention
NRB buys/sells foreign currency without neutralizing the impact on the money supply.
Example in case of Nepal:
- NRB buys USD due to high remittance inflow → NFA increases
- NRB pays NPR into the system → RM increases
- NDA remains unchanged
Effects:
- Increased money supply → potential inflation
- Lower interest rates
- Monetary policy becomes expansionary
| Component | Before | After |
|---|---|---|
| NFA | ↑ | ↑↑ |
| NDA | - | - |
| Reserve Money (RM) | ↑ | ↑↑ |
Sterilized Intervention
NRB neutralizes the monetary impact of forex intervention using tools like open market operations (OMOs).
Example in case of Nepal:
- NRB buys USD → NFA increases
- NRB sells bonds → NDA decreases
- RM remains unchanged
Effects:
- Exchange rate stabilized
- Money supply controlled → no inflationary pressure
- Monetary neutrality preserved
| Component | Before | After |
|---|---|---|
| NFA | ↑ | ↑↑ |
| NDA | ↓ | ↓↓ |
| Reserve Money (RM) | → | → |
Summary Table
| Feature | Unsterilized Intervention | Sterilized Intervention |
|---|---|---|
| Change in NFA | Yes (e.g., ↑ from USD inflow) | Yes (e.g., ↑ from USD inflow) |
| Change in NDA | No | Opposite direction (↓ if NFA ↑) |
| Change in Reserve Money | Yes | No |
| Impact on Liquidity | Increases | Neutral |
| Impact on Inflation | Expansionary (Possible Inflation) | Neutral |
Note: In Nepal, the central bank often uses sterilized interventions to manage the effects of large remittance inflows and maintain monetary stability under its fixed peg to the Indian Rupee (INR).
Challenges for Nepal in Sterilized Intervention
1. Limited Depth in Bond Markets
2. Cost of Sterilization
3. Sustainability of Intervention
4. Exchange Rate Rigidity
5. Coordination with Fiscal Policy
6. Liquidity Management Capacity
7. Volatility in Remittances and Capital Flows
8. Underdeveloped Money Market Instruments
9. Crowding Out Effect
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