mariners, it lures residents and regulators with its enchanting promise of easy liquidity and growing domestic equity and bond markets. however, this vast sea also holds many dangers. it is affected by fierce forces that can create violent and destructive waves. even when it is calm, beneath that calm surface there are dangerous currents. to the unwary, who wade in too far, it can drag them to financial ruin, be they businesses, individuals, or governments. beneath its surface are hidden rocks that can drive even successful economies to the bottom of the sea. the challenge for em policy makers in a globalised financial system is not that different from the one faced by a fisherman who lives by the sea, and that is, how to benefit from the riches offered by the sea while avoiding the dangers. so let me now turn to how i believe we can do that. reaping the benefits and mitigating the risks the question i would like to pose and attempt to answer is : “ what can emes do to strengthen their buffers and increase their resilience against the risks arising from integration with the global financial system? ” i am going to frame my answers within three broad categories : one, in terms of reducing external vulnerabilities, two, in terms of improving policy frameworks ; and three, in terms of strengthening domestic economic fundamentals. first, in terms of external vulnerabilities, i think storms in the global sea of liquidity are a source of concern, but for policy makers in emes, the consequential concern is how seaworthy is our own boat? can it withstand a stormy sea? in my observation, capital flows often tend to accentuate domestic vulnerabilities and that can create the greatest risk of financial instability. for those who choose to borrow from the international financial markets, it is good to remember that even in a world of abundance, restraint is a virtue. like the sirens of greek mythology, the international banks may go around emes telling them how easy it is to get funding. however, like the ancient mariners, governments and corporates in emes would do well not to heed those sweet - sounding siren calls. a period of low global interest rates may be a good time to re - finance old debt but it is never a good time to accumulate excessive debt. bis central bankers ’ speeches the temptation is strong, especially when the domestic interest rates are higher. central banks and regulators need to monitor the use

financial system more generally in many economies ; second, through stimulatory fiscal policies ; and third, through supportive monetary policies – very low interest rates and direct injections of money to support demand in a low interest rate climate, such as the mpc ’ s policy of “ quantitative easing ”. however, the current level of stimulus from monetary and fiscal policy was designed to turn around economies in the wake of the traumas we experienced 12 – 18 months ago. as confidence builds and private spending recovers, it is likely to be appropriate to gradually withdraw at least some of this policy support for demand, without jeopardising growth prospects. the need to re - adjust economic policy is most obvious on the fiscal side, where deficits are very high by historical standards, particularly in the us, europe and japan – as chart 7 shows. these large deficits reflect the important role that public spending and tax policies have played worldwide in stabilising economic conditions during the recession. but to ensure sustainable public finances over the medium - term, these budget gaps will need to be closed over the recovery. in many countries, policy - makers are rightly concerned about the negative consequences for demand of tightening fiscal policy too quickly and abruptly while the recovery is still fragile. but a tightening of fiscal policy which is pursued as part of a longer - term, credible and well worked - out plan is much less likely to have such negative demand - side effects, and may have offsetting benefits for the supply - side performance of the economy. progress in putting public finances on a sounder footing can increase confidence and reduce uncertainty about future economic prospects, providing a much better climate for a recovery in private sector demand. it can also support the supply - side performance of the economy by helping firms and individuals plan for the longer term. the effects of deficit reduction on financial markets should also be positive for private sector demand. long - term interest rates are likely to be lower in a world in which government deficits are being reined in, and the risk of destabilising financial market movements is also reduced. again, this is likely to provide a much better climate for private sector investment and long - term spending and planning more generally. an additional mechanism through which the negative demand - side consequences of fiscal tightening can be offset is by maintaining a relatively loose or relaxed monetary policy. so the other arm of withdrawing policy stimulus – a tightening of monetary policy – needs to take into account the potential impact of deficit reductions on demand,