So far, I would say that improvements in Fund surveillance, its policy advice, as well as the transparency it encourages have led to sound policies, better institutions, and overall greater flexibility in emerging markets. A big pay-off was evident last year when the improved economic resilience enabled emerging markets to cope better with the impact of the high oil price. But, definitely, more can be done. And the first point I want to make is that IMF surveillance would be most useful for emerging markets if it strengthens its focus on helping members to better prepare for coping with the challenge of the next crisis. My view is that, with the improvements in economic fundamentals and policies that we are now seeing within emerging markets, there is now less likelihood than before that the next crisis, if it were to occur, will originate from imbalances within emerging market economies. On the contrary, imbalances now seem to be more of a challenge for the major economies with the financing now becoming a major component of the global capital flows. An unwinding of the imbalances could lead to economic slowdown and sudden changes in the financial conditions of the major economies, which, as the past episode of capital account crises shows, can create difficulties for emerging markets in terms of growth implications, abrupt reversals of capital flows and sudden stops.
Two factors played leading roles in that development. The first is the relatively large share of foreign-denominated loans – an average of 20% for households and 70% for businesses. The latter factor is an unusually strong exchange rate pass-through effect, which stems from the magnitude of the exchange rate drop and the lack of confidence that the króna would recover in the near future. As a result, the principal of indexed loans – which constitute about 70% of household debt and 10% of business debt – was written up. As is often the case in severe financial crises that are at the same time country crises, there was a genuine risk of a multi-faceted spiral of currency collapse, inflation, debt crisis, and economic contraction. It was critical to stave off such a vicious cycle, and therefore of vital importance to stabilise the exchange rate. BIS Review 146/2009  1  But this was problematic because of the large amount of capital that had accumulated in Iceland through carry trading during the economic upswing. Current estimates indicate that some 500 b.kr. remain in the Icelandic economy. There was the risk that this money would try to escape through a collapsed foreign exchange market, with unimaginable consequences for the exchange rate. Thus it was quite possible that astronomical interest rates would have been required if exchange rate stability were to be achieved through interest rate policy alone.