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The conventional wisdom is that central banks can intervene in foreign exchange markets to resist currency appreciation for some time because there is no simple, clear ceiling to the volume of domestic currency they can sell in forex markets. Equally conventional is the view that prolonged, large-scale intervention must eventually weaken domestic macroeconomic performance-whether because of higher inflation, the costs of misaligned exchange rates or distortions in the financial system or the exchange rate/maturity exposures built up by the public sector. Yet massive intervention during the five years 2000 to 2004 by the major emerging market central banks-especially Asian central banks-has not apparently had such negative effects. Indeed, inflation has been low, financial systems appear stronger and there has been sustained growth. What has happened? This paper seeks to answer this question.

The main reason for policy dilemma is that intervention in the foreign exchange market has direct implications for the stance of monetary policy. In some circumstances, the central bank may want both to resist currency appreciation and to ease monetary policy. If so, intervention would create no conflict with monetary policies. If not, the central bank would have to ensure that money market rates are held constant in the face of intervention; some would express this alternatively in terms of holding the monetary base broadly unchanged. This is the process of sterilisation. 2