The period leading up to and immediately following the Asian financial crisis is a prime example of this interaction. In that case, rapid movements of capital flows into and out of emerging markets interacted with financial system underdevelopment, deficient bank supervision, and balance sheet weaknesses, resulting in a boom-bust cycle. In contrast, the experience of developed economies is more generally characterized by one where large shocks typically result in substantial asset price volatility and substantial financial losses that are not accompanied by significant disruption to either short run or long run economic growth. A rigorous assessment of the challenges of monetary and financial stability in emerging market economies therefore must explicitly recognize this underlying difference in the economic backdrop. Let me now turn to the second part of my lecture and discuss the implications of these differences on the pursuance of monetary policy and financial stability. In light of the unique agglomeration of factors in emerging market economies outlined above, the pursuit of monetary and financial stability in emerging markets has two key facets. The first is to address the immediate short run concerns emanating from the various shocks; and the second is to implement structural reforms to ensure that financial stability becomes embedded in the underlying economic structure of emerging markets in the long run. The former essentially concerns the challenge of maintaining economic stability through appropriate policy settings and actions to offset the various shocks hitting the economy at any given point in time.

The latter, on the other hand, focuses on strengthening the institutional framework for monetary policy and financial supervision as well as fostering financial sector development that improves the ability of the system to absorb shocks by itself, in a way that minimizes the impact on the real economy without the need for policy intervention. Given the significant gap that emerging market economies have in this respect relative to developed economies, it becomes more crucial that the pursuit of monetary and financial stability in emerging markets be accompanied by a vigilant focus on making progress on structural reforms. In what follows, I will discuss some specific challenges to monetary and financial stability in emerging markets from both the short and the longer run perspectives. Let’s begin first with the short run stabilization challenge. As we have seen in past years, the search for yield among international investors has resulted in a resurgence of capital inflow into emerging markets, leading to a pick-up in asset price volatility. 3 Given the high degree of dependence on foreign trade, and the inadequate experience with modern financial risk-management tools particularly at the firm level, these asset price fluctuations have become an important policy issue in emerging markets. Typically, when large capital flows into financially shallow markets, it puts pressure on emerging market central banks to lower interest rates or to increase sterilized intervention in  3  This global liquidity glut may have stemmed from various factors, both structural and cyclical.