If the increase in oil prices is sustained, the expected decline in annual HICP inflation rates to below 2% later in the spring could be less pronounced – and inflation rates during 2002 could turn out to be somewhat higher – than we expected in late 2001. Beyond the shorter term, in the light of current expectations of a gradual economic recovery in the euro area, upward pressure on prices from aggregate demand should remain contained. However, this outlook for inflation is fundamentally dependent on continued wage moderation. In this respect, there is some cause for concern with regard to ongoing wage negotiations. The economic downturn in the euro area in 2001 also presented challenges for fiscal policy. Since some countries came close to the 3% limit for the deficit to GDP ratio, the experience of 2001 clearly  2  BIS Review 26/2002  demonstrated the need for all countries to undertake consolidation efforts in good time to ensure a fiscal position close to balance or in surplus before the start of a downturn. In order to prevent problems like those experienced last year from recurring in the future, it is vital that the commitments made to achieving balanced budgets by 2003-04 be firmly followed up in the Member States concerned. Finally, I would like to highlight the need for structural reforms aimed at improving the functioning of product and financial markets. If implemented vigorously, these reforms can increase euro area growth potential and employment on a sustainable basis.

Thus, it is imperative that emerging market devise a proper strategy and process to expedite reforms and develop the financial system. The second long-term reform I want to bring up is on policy institution and framework. On this, two institutions are upmost important for attaining monetary and financial stability. The first is a credible monetary framework that effectively anchors the public’s expectation of inflation. On this, the key issue is the importance of independence and transparency of the monetary policy process. Our view is that lack of independence can come at a great cost in terms of lower central bank credibility and a less favorable trade-off between inflation and output volatility. Likewise, weaknesses in monetary policy transparency can contribute to policy uncertainty and exacerbate the impact of shocks on macroeconomic volatility. The second important policy institution is an effective supervisory policy and domestic financial institution’s capacity for sound risk management. The logic for this is clear. With less effective supervision and limited capacity to manage risk, the ability of the economic system to absorb volatility from global markets is significantly compromised. Reflecting this emerging market has put enormous emphasis on building up the necessary institutions with regards to effective supervision. But the challenges are many. For example, at this time many emerging markets are facing the challenge in implementing Basel II. (i)  Stronger risk management culture  The objective of Basel II is to strengthen the soundness and stability of the banking system through more risk-sensitive capital requirements and rigorous internal risk assessment process.