BIS Review 98/2008  3  Such volatility, which sometimes manifest itself in “sudden stop”, is linked to a variety of factors including the pro-cyclical nature of the flows. For example, the pro-cyclical nature with respect to sovereign bond ratings. On the other hand, information asymmetries in emerging market economies may also make the flows more susceptible to contagion effect, resulting in large swings in capital flows unrelated to changes in fundamentals. Macroeconomic conditions in developed countries is another factor that can make emerging market economies more susceptible to a wide array of global shocks. And lastly, domestic political shock in the form of policy uncertainty can also be more pronounced in emerging markets, as evidenced by more frequent regime switches, that is from fixed to floating exchange rates, as well as reversals in policies. Such shocks can exacerbate capital flow volatility and manifest themselves in terms of greater macroeconomic volatility. The second key difference between emerging market economies and developed economies has to do with structural features of the economic system that influences how various shocks are propagated through the economy. While there are many key differences in this regard, two features are especially important in the context of monetary and financial stability. The first is the financial development and the second is the institutional framework of monetary and financial supervision policy. On financial development, one of the most vital foundations of modern economies is the process of channeling resources to their most productive uses.

In the context of financial sector reforms, for example, the underlying challenge is the proper mitigation of the additional risks that are injected into the financial system as markets develop and become more sophisticated. These risks consist of both financial risks borne by market participants as well as macroeconomic risks that may be associated with greater financial market volatility. Indeed, the inappropriate setting of priorities among the reform measures or an overly rapid pace of change can result in financial instability in the short run. More generally, initiatives in the areas of financial sector development, monetary policy regime, and capital account liberalization are all closely related and designing appropriate reforms in one area requires a careful consideration of how to proceed with the others. On this issue, suffice it to say that the consensus on the importance of structural reform efforts does not carry over with the same strength to the issue of the appropriate pace and sequencing of policy changes. Nonetheless, it should be stressed that a frequent outcome of the debate on this issue is excessive inertia in reaching an agreement and actually starting the process of change. The more protracted the transition period, the greater the eventual costs to the economy in terms of deferred benefits of stronger fundamentals. Finally, a recurrent theme that has been underlying much of the discussion in this lecture this evening is the intricacy of achieving monetary and financial stability while at the same time maintaining the delicate balance of short-run stabilization efforts and long-run structural reforms.