Market Stabilization Scheme (MSS) is aimed to sterilize the excess money supply created due to foreign exchange market intervention by the RBI. The stabilisation through withdrawal of excess money supply is done by issuing market stabilisation bonds (MSBs) to financial institutions. The entire process is a time taking one and needs the cooperation of the government as it is the government that gives the Market Stabilization Bonds to the RBI.
Why MSS?
During several years, foreign capital inflows flood the foreign exchange market and thus cause appreciation of the currency. Too much appreciation is undesirable as it often reduces exports and increases imports and thus worsens the trade account. Central banks especially that of EMEs follow intermediate exchange rate systems (for example, managed flexibility in the case of India) where, exchange rates are stabilised through intervention of the central bank in the foreign exchange market. Intervention can be in the form of selling of foreign exchange during depreciation pressure or buying of foreign exchange during appreciation.
Managing exchange rate during capital inflows means the RBI should take care that excess appreciation is not hampering exports and thus worsening the trade account. So during high appreciation the RBI buys foreign exchange to check appreciation. In the process, it releases domestic currency while purchasing foreign currency. This expanded domestic money supply should be withdrawn otherwise it may produce inflation. For the purpose, central banks launch the programme of sterilisation.
Sterilisation in the context of monetary policy refers to the activity of the central bank of taking away the excess money supply created due to its foreign exchange market intervention.
