This has allowed the financial system to better intermediate highly volatile capital flows. Despite this, the surges and reversals of capital flows continue to present a major challenge to policy. Specific policy strategies have also been adopted to reduce the prospect of being destabilised by these flows. Financial reforms following the Asian financial crisis have transitioned financial systems in Asia towards greater market orientation and increased exchange rate flexibility. This has facilitated greater capacity to adjust to the increased volatility in the financial system. Further progress on liberalisation has also increased the potential to undertake foreign exchange transactions, including engaging in outward portfolio and direct investments abroad. This has resulted in stronger two-way capital flows, contributing to more orderly conditions in the financial markets. Liquidity management measures, prudential regulations including macro-prudential measures, and more interventionist measures that include restrictions on such flows, have also been implemented in varying degrees to cope with the volatile capital inflows. For the most part, prudential regulations, such as the imposition of ceilings and limits on external exposures, or minimum holding periods for specified domestic instruments, but which have not discriminated according to residency, have been implemented. Overall, they have enabled the financial sector, markets and the economy to function without disruption during the period of the global financial crisis. While policies at the national level are important, these have been complemented by a higher level of regional collaboration and cooperation. The Asian region is now well ahead in the areas of surveillance arrangements, financial safety nets and crisis management.

The deleveraging by banks was, in particular, felt in 2009, following the actions by banks in the United States to strengthen their capital positions, and more recently by banks in the Europe to meet the new capital adequacy requirements. In view of the challenging conditions for capital raising, this is being achieved, in part, by asset reduction, either by asset sales, in particular in performing economies, or the withdrawal of credit lines. These operations not only have implications on asset prices but on currency movements, as funds from the asset disposal are remitted back to the home country. The reversal of capital flows following such deleveraging is thus accompanied by a correction in asset prices and depreciation in the currencies. For emerging economies, the more developed and liberalised the financial markets, the more significant will be the impact of such activities, and the greater will be the amplitude of the volatility in the asset prices and currency movements. Global policy spillovers have also been transmitted to the real economy through trade and investment flows. The world economy, including emerging economies, benefitted immensely from the fiscal stimulus that supported the economic recovery. However, as the deterioration in fiscal sustainability became a concern, the effects of the pull-back in public expenditure on growth have contributed to slowing world trade and cross-border investment activity. Emerging economies, in particular in Asia, have seen the export sector slow significantly.