However, if the domestic financial system is underdeveloped and financial institutions are not adequately supervised, as external hot money increases the deposit base of domestic banks they may be lured into fueling domestic asset price bubbles. These have two major consequences. First, asset price inflation eventually leads to domestic inflation and erodes external competitiveness. Second, excessive lending concentration in real estate exposes financial institutions to large non-performing loans when oversupply of property emerges. Indeed, banks are absorbing credit risk on top of interest rate and exchange rate risks. In some Asian economies, weakness of the financial system has constrained the ability of the monetary authorities to raise interest rates to defend their currencies when the exchange rates are under pressure. Conversely, to allow the currency to depreciate exposes banks and other borrowers to exchange losses on their unhedged foreign currency liabilities. 26. At the same time, the external environment has been changing. Whilst Asia was enjoying an unprecedented boom, the global competitive environment was subtly but surely shifting, which led to portfolio rebalancing by global asset managers. The adjustments in the US economy, through fiscal and monetary tightening, and technology and corporate restructuring, had brought substantial benefits in the form of lower budget deficits, and the lowest levels of unemployment and inflation for decades. In case anyone forgets, the US equity market has in the last three years outperformed almost all Asian equity markets with the exception of that of China.

But the down side risk which all of us should be aware of is the possibility that the global financial market may then become segmented into regional blocs which may result in more competition and friction, rather than co-operation. 11. On the form of monetary co-operation, there is a wide spectrum of experience on the basis of current practice. There is on the one extreme the simple exchange of information and expertise amongst monetary authorities helpful to the management of the domestic monetary system generally, covering the whole range of central banking functions in the management of the currency, the supervision of financial institutions, the development of the financial infrastructure, the management of foreign reserves, etc. On the other extreme, there is monetary co-operation to the extent of achieving monetary union or integration. 12. In between the two extremes there are arrangements for policy co-ordination at the macro level initiated on the realization of increasing international, particularly regional, economic interdependence. There are also the more focused schemes for mutual assistance in the provision of liquidity to facilitate effective monetary management, which may or may not involve the assumption of credit risks between governments. There have also been considerable efforts spent in supervisory co-operation towards the standardization of supervisory practices in order to promote international financial stability, again in recognition of the possibility of the damaging contagion effect of financial crises across financial systems.