Soft-peg problem

Analysts had warned at the time that sterilizing the rupee liquidity arising from dollar inflows (resisting an increase in the monetary base) and taking dollars out of the country as central bank foreign reserves cancelled out any potential benefit to the economy from capital inflows generated from bond sales.
At that interest rate the government could have raised the same amount of money from the domestic market, with the same 'crowding out' effect on the private sector with no foreign exchange debt liability and consequently no increase in foreign reserves.
This is a common problem associated with sterilizing soft-pegged central banks that try to control money supply while maintaining a managed (dirty) float or peg, and has been documented by economists in a wide range of pegged-exchange rate central banks ranging from Mexico to China.
The central bank says foreign investors who bought bonds were liquidating "a certain part" of the foreign investments in government securities due to the financial crisis in their own economies.
"While these demands have been comfortably accommodated so far, the Central Bank also stands ready to accommodate any further outflows, if such outflows arise at any time in the future," the Central Bank said.
While the Central Bank could 'accommodate' any dollar outflows arising from maturing bills directly from its reserves without affecting the domestic monetary system, analysts warn that 'accommodating' any sales of unexpired securities to the local market would result in further inflationary and foreign exchange pressures on the monetary system.
Currency crises usually arise from such central bank actions.