Sterilized intervention, however, entails quasi-fiscal costs from swaps or bond issuance, which adds to the liability side of the consolidated public sector balance sheet. Since the debt is in local currency, there is an inflation risk attached to it should there be future fiscal stress. There is also a potential for the market to raise doubts about monetary policy independence and therefore increase the risk of policy uncertainty. In the same vein, accumulating international reserves can also lead to a possible damage to central bank credibility in some countries, as they incur balance sheet losses when assets and liabilities are marked to market in local currencies. In sum, the challenge of containing the effects of capital inflows on asset prices may pose risks to future inflation and financial stability in emerging markets. This challenge seems to suggest a potential for complementing monetary policy with prudential measures. The extent of the challenge here depends crucially on the ability of the economy to cope with asset price fluctuations. Also, it depends critically on the ability of the real sector to adjust to the pace of the appreciation as capital inflows continue. Next, the second challenge in the near term concerns the ability of emerging market central banks or financial supervision authorities to identify and quantify risks of potential financial instability in advance. In this context, stress-testing is one of the most powerful tools to assess financial stability ex-ante.

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