. however, indirect effects via lower global commodity prices could become quite pronounced. • increases in the us interest rates and investors'reduced appetite for risk could lead to significant widening of the emerging market spreads. liquidity in some markets could dry up causing spreads to widen further as investors would try to reduce their exposures. and currencies in the region could come under pressure to weaken as investors would try to exit certain markets. • contagion, which has been vanishing in recent years, could reappear as spreads would widen and investors try to beat others in their attempt to adjust their portfolios. related to this, the original sin could also return as countries would have increasing borrowing needs in the face of a deteriorating economic outlook and weaker fiscal balances. • one big question mark would be the role that credit derivatives might play in the propagation of the crisis. at the moment there is much uncertainty about the way credit risks have been distributed in the financial system and the issue who is their ultimate holder. possible problems in the credit derivatives market could spell further trouble for emerging market borrowers. these issues are analyzed in great detail in the forthcoming issue of the ecb's financial stability review that will be published any day now. • declines in stock prices and increases in bond yields could weaken domestic balance sheets. these factors, and a generally weaker economy, could put a strain on domestic financial institutions. • fiscal balances could be hit through many channels : weaker economy, higher debt service as a result of higher interest rates and possibly also weaker currencies. possible problems in the domestic financial systems could also force governments to incur additional liabilities. countries with sound fiscal positions and well - anchored inflation expectations might have some scope for countercyclical policies. such countries could also benefit from flexible exchange rates. however, in cases where the fiscal position is not sound enough, and if currency mismatches of debt would erode the potential benefits of exchange rate flexibility, there would be very little that the authorities could do after the onset of the vicious circle. this analysis underscores the urgency to tackle the remaining vulnerabilities before a crisis. specifically : 1 ) fiscal vulnerability needs to be reduced through more ambitious fiscal consolidation and further improvement in debt management practices. and 2 ) financial sector vulnerability can be reduced through enhanced supervision and by measures that support further development of deeper and more liquid markets. one challenge related to the financial sector is making domestic private sector balance sheets more resilient to potential

economic shocks. a more recent concern in some countries is the build up of a potentially excessive exposure of the domestic financial system to domestic ( non - indexed ) government debt. before turning to discuss the policy implications of these remaining vulnerabilities, i would like to emphasize that advances in institutional development can never be taken for granted. indeed, as we have seen in the past, populist policies can easily cause setbacks in this area. therefore, it is crucial to maintain the political support to institutional reform that fosters financial development. in this regard, strong property rights and a legal system that enforces contracts quickly and fairly are of particular importance. as many of you may recall, we discussed the topic of globalization and financial stability last summer here in banco de espana and safeguarding these two factors were deemed as essential to avoiding pitfalls in financial liberalization. 2. possible " anatomy " of the next crisis and the policies to increase resilience to shocks the region weathered relatively well the may - june 2006 financial market correction, but this episode showed that it has not become immune to shocks emanating from the global financial system. while the " threshold of pain " has clearly improved, the resiliency of the system in the face of a more pronounced external shock remains untested. against this background, there is no room for complacency. so, what might a more serious external shock look like and how can the authorities prepare the economies for such an eventuality? the region seems particularly vulnerable to the combination of a possible recession in the us and falling commodity prices. let me elaborate on this a bit to examine the anatomy of a worst case scenario. i want to emphasize that i am by no means implying that this type of outcome is likely and that there would inevitably be important differences between the countries in the region. nevertheless, and at the risk of overgeneralising and oversimplifying, i think that it is useful to examine how a vicious circle might unfold in order to draw some policy conclusions. • a recession in the us ( triggered e. g. by wider decline in housing and other asset prices ) would hit harder those latin american countries that have the strongest trade links with the us, such as mexico, venezuela and ecuador. a weaker us demand could well lead to a significant slowdown in china. direct impact on the region might be relatively limited as the direct trade links between china and latin america are relatively weak, despite some increases in recent years