Most studies of monetary sterilization seek to determine how effective such policies are and typically do not address the issue of sustainability. Those works that do consider sustainability find that sterilization is possible in the long run if domestic interest rates remain below foreign rates; if capital markets are imperfect; or if the scale of sterilization does not become too large. This paper asserts that sterilization may not be possible in the long run since it engenders a spirit of moral hazard, thus increasing systemic risk within the banking system, leading to a highly risky, speculative bubble. Loading the banking system with low risk, low yielding sterilization assets encourages banks to seek out riskier investments to balance their unduly secure portfolios. China is considered to be a good example of this phenomenon. China has engaged in massive sterilization over the last five years and has consequently experienced a bubble in lending. As a result, China will quite likely be forced by objective circumstances to reduce the scale of its sterilization efforts and allow greater flexibility of its currency in the future.
Tamkang Journal of International Affairs 14(2), pp.43-89