6  BIS Review 8/2007  Therefore, continued regulatory vigilance and timely interventions would be necessary to avoid and/or mitigate any harmful effects of all such threats. It should also be noted that a continuing high budget deficit could also pose a formidable challenge in the conduct of monetary policy, as such deficit requires borrowings by the Government from the banking system, making it difficult to maintain the monetary expansion along a pre-determined, tight path. As seen from the case studies of many successful countries, rapid infrastructure development is a strong contributory factor towards achieving sustainable high growth. However, the timely mobilisation of necessary resources for infrastructure development while maintaining budget deficits and debt at reasonable levels would be particularly challenging for a developing country like Sri Lanka. At the same time, maintaining a comfortable and reasonable level of foreign currency reserves in order to be able to mitigate the impacts of external shocks is also a challenging task for any developing country. Needless to say, it is vital to manage the foreign reserves at an appropriate level, while ensuring that the exchange rate fluctuations are within reasonable limits, in order to enhance the confidence in the economy. These and other challenges would need to be faced by our country and it is clear that our policies and actions would have to be so designed in order to deal with, and respond to, such challenges if we are to be successful. 5.
7  All speeches are available online at www.bankofengland.co.uk/news/speeches  7  For example, micro data studies from the UK, US, Denmark and Norway have all found statistically significant correlations between higher levels of household debt and the size of consumption cuts in a shock.13 And macro studies have also found correlation between rapid credit growth and the severity of downturns.14  But new studies have also sought to deepen the knowledge base. In particular, they have looked at why more highly indebted households cut consumption in response to shocks – the channels through which the observed association is working. For example, there could be debt financed ‘over-consumption’ prior to a downturn that is then cut back when expectations adjust to reality or credit becomes unavailable. This channel might work directly through unsecured consumer borrowing or through mortgage financed borrowing to consume. Alternatively, there are channels through which higher levels of debt constrain household budgets without appealing to ‘over-consumption’: some indebted households may be unable to consume as much as they would like in a downturn because they do not have a sufficient buffer of liquid savings and find themselves unable to access additional credit when they need it the most. This situation is more likely when falls in house prices reduce the value of the borrower’s collateral. The situation is also likely to be exacerbated if the downturn is accompanied by rising uncertainty. The combination of rising uncertainty and credit constraints would tend to lead to further reductions in spending as households build precautionary buffers.