The macro and micro prudential policies of EMEs in the previous decades have succeeded in lowering levels of leverage, not only in financial sectors, but also in nonfinancial and household sectors. This, in turn, lowered levels of maturity and currency mismatches. This gave rise to high capital adequacy ratios and low non-performing loan rations in banking sectors of many EMEs. Moreover, in relative terms fiscal positions of EMEs have further strengthened while those of AEs have worsened in the aftermath of the GFC due to sizeable fiscal stimulus policies. Keeping this systemically important sector free from solvency risk has helped EMEs gain business confidence (Figure 9). Lower deficit and debt levels imply ample policy spaces for EMEs in cases of economic downturn. Creditworthiness together with policy spaces on the EM fiscal fronts have contained upward pressures on interest rates and have kept the effectiveness of other policies intact. It is fair to say that they now look strong enough to render the adverse effects of external financial shocks manageable.8 Policy actions in EMEs However, the current unconventional monetary policies of AEs in the form of low or even negative nominal policy rates as well as quantitative easing and unintended consequences of the financial sector reforms across the world pose new challenges to EMEs. Until recently, because of better growth prospects and lower levels of leveraging, EMEs attracted capital inflows with their nonfinancial corporates having lion shares.
As a result, stock and flow balances, policy frameworks, and levels of economic confidence and market development in EMEs have strengthened substantially and radically. Stock ad flow balances Since EMEs mostly suffered from sovereign debt crises, fiscal discipline has been the cornerstone of the first generation of structural reforms. Prudent fiscal policies have played a key role in maintaining low budget deficits and hence lowered debt levels to the extent that budgets delivered primary surpluses (Figure 4). Lower interest rates implied by diminished financing requirements of the government sector then further reinforced fiscal positions. As a consequence, the share of government bonds in emerging debt markets has declined and created room for the private sector debt market to grow. Private debt levels in emerging markets have also stayed at moderate levels on average (Figure 4). Declined public debt also implied lower bases for external debt. In addition to this development, EM governments have consciously borrowed less in foreign currencies in the wake of their earlier financial crises. Combined effects have, on average, reduced government owned external debt to GDP ratio from 28 percent at the beginning of the 2000s to 18 percent in 2014. This decline in Eurodollar loans manifests deepened domestic debt markets and hence have reduced the so called “original sin” problem of emerging markets to the extent that foreign investors willing to lend in domestic currency as opposed to hard currencies. It is argued that one of the factors that created economic instability in EMEs is the “original sin” problem.