When an economy experiences large, continuous inflows of foreign capital, the central bank must absorb the foreign currency to prevent extreme exchange rate appreciation. However, sterilizing these transactions long-term can strain the central bank’s balance sheet.

To absorb the excess domestic liquidity generated by FX purchases, central banks issue their own short-term debt instruments, known as Central Bank Bills, or pay interest on large commercial bank reserve balances:

Sterilization Net Margin = Foreign Asset Portfolio Yield - Central Bank Bill Interest Payout

If domestic policy interest rates are significantly higher than the yields earned on international reserve holdings (e.g., US Treasury yields), the central bank faces a negative spread. This operational drag can lead to financial losses, requiring careful management of liquidity absorption settings.