These three sources of risk call for different policy actions. The first approach for dealing with asset price misalignments is for authorities to communicate their views on the extent of potential asset price distortions and their consequences for financial stability. These “verbal interventions” are relatively common regarding the exchange rate. I see no reason why we should not use them also for other assets such as bonds and equity, since they are relevant variables from the point of view of macroeconomic and financial stability. Indeed, recent experience has shown that central banks need to be more assertive and communicative about the conduct of financial systems. In our last Financial Stability Report we indicated that evidence pointed to some overvaluation of stock prices in Chile, but we also indicated that financial stability was not threatened by potential corrections, even sharp corrections, in these prices. Of course, making this assessment is not a trivial task – as modeling asset prices is complex – and it is not the role of central banks to communicate continuous assessments of asset prices. For this reason, this kind of communication must be done exceptionally, and in the context of discussing the potential implications of these price developments on current and future  BIS central bankers’ speeches  3  financial stability. In addition, communication must be done in a timely manner, before vulnerabilities build up.
2  BIS central bankers’ speeches  advanced economies recovers more strongly. Therefore, over time some tensions should alleviate, and this depends crucially on a healthy recovery of advanced economies. The cyclical difference between EMEs and advanced economies, with the consequences on expected relative returns and risk, is inducing large gross capital inflows to EMEs. Net capital inflows, however, are well below the levels seen in the early 1990s. Indeed, at this time EMEs are running current account surpluses on average, while in the early 1990s deficit predominated. In the case of Chile, we have not seen net capital inflows yet. But, as the adjustment progresses we should observe rising net capital inflows to EMEs. In addition, large gross capital inflows raise concerns from a financial stability perspective, an issue to which I will turn next. Financial stability and capital inflows We can think of three ways through which unsteady gross inflows may affect financial stability in a country. The first one is that in small and often illiquid markets capital inflows may increase asset prices beyond fundamentals. The problem arises if asset prices respond significantly to inflows, and these inflows stop or revert suddenly. A sharp decline in asset prices affects the balance sheets of local and foreign agents. If, in addition, the financing of asset purchases is highly leveraged, the fall in asset prices may trigger solvency problems, just as those of the subprime crisis.