The normalization of global monetary policies has reversed the course of capital flows and led to the sizable depreciation of EM currencies against the dollar. This creates inflationary pressures due to the pass-through impact and impairs balance sheets due to tightening global financial conditions and worsening growth prospects. Furthermore, the sharp fall in oil prices exacerbates the deterioration in economic outlook for commodity exporting countries. Going forward, the normalization of US monetary policy, diverging monetary policies of AEs, uncertainty in commodity prices and the  8  Kenç, Turalay, Fatma Pınar Erdem and İbrahim Ünalmış (2016), Resilience of Emerging Market Economies to Global Financial Conditions, Central Bank Review, forthcoming. BIS central bankers’ speeches  5  risk of China’s economic hard-landing all will be likely to contribute to volatile global financial markets and widening spreads for EMEs. Large asset purchasing programs of the major central banks have depressed global bond markets with decreasing long-term yields as well as short-term yields and their negative nominal policy rates further destabilized bond markets and in general financial markets. Heightened volatility in global financial markets (Figures 10–11) can be associated with the presence of very low and even negative rates rather than the underlying macroeconomic and external imbalances. In these circumstances, any change in interest rate differential across countries will likely create greater impacts than otherwise. If this interest rate change takes place in the largest and most significant economy in the world, then the impact will expectedly be magnified further.

Sub-prime borrowers defaulted because they were living beyond their means: their stock of debt exceeded their ability to repay. The shattered camels were bank (and shadow bank) balance sheets around the world. Government balance sheets buckled next as they sought to sustain demand and employment. What should financial policy and monetary policy be doing right now? With credit conditions so tight, it has been asked whether the Financial Policy Committee should be employing macroprudential tools to ease regulatory constraints on banks, with the aim of encouraging them to loosen lending conditions, helping recovery and so reducing threats to stability from default risk. The FPC concluded at its September 2011 meeting that such a step would in fact be counterproductive, endangering stability and jeopardizing recovery. Given their precarious starting position when the crisis broke, the capital adequacy of UK banks is still being rebuilt. Worse still, the lingering threat of a severe crisis in the euro area leaves banks operating in an extraordinarily risky environment. While in other circumstances it might have been possible to relax capital requirements if the worst had passed, it is not a sensible course when the worst might still lie ahead. In current circumstances, gradually building resilience through retained earnings is best for stability and recovery, because it helps preserve the capacity to lend “the day after tomorrow”. This leaves monetary policy with its classic role of underpinning demand. Here and elsewhere, central banks have injected extraordinary monetary stimulus.