The first is addressing the immediate short run concerns emanating from various shocks; and the second is implementing structural reforms to ensure that financial stability becomes embedded in the underlying structure of the economy in the long run. In terms of challenges, the former essentially concerns the challenge of maintaining economic stability through appropriate policy settings and actions to offset the various shocks hitting the economy at any given point in time. The latter, on the other hand, focuses on strengthening the institutional framework for monetary policy and financial supervision as well as fostering financial system development that improves the ability of the system to absorb shocks by itself in a way that minimizes the impact on the real economy without the need for policy intervention. Let me now discuss some specific challenges to monetary and financial stability in emerging markets from both the short and the long run perspectives. For short-run stabilization, it is clear that one of the important challenges at present is how to contain financial vulnerabilities that accompany an influx of short-term capital. In coping with capital flows, lowering interest rates to reduce the relative attractiveness of the country to capital inflows may be a first appropriate way to ensure price stability. But, in most cases, fast appreciation may not subside as exchange rates tend to behave more like asset prices than relative goods prices.
Efficient and well balanced financial system will allow the system to better manage and absorb shocks as the market would be less prone to one-way market conditions and possesses greater liquidity. A well balanced financial structure contributes positively to information processing, price discovery, and risk management. The experience of the Asian crisis, for example, points to the critical importance of the development of long-term local currency debt market, to increase the depth and the breadth of financial market. In relation to this, BIS identified that the lack of diversified structure and market may lead to increased risk from concentration of credit and maturity risks in the banking system as lack of markets may lead to the mispricing of risk and excessive delay in correcting large exposures, as well as increased vulnerabilities from capital inflows. The second point we want to make is the importance of strong financial market infrastructure. One of the key issues for emerging markets is the structural weaknesses which can create disincentive and moral hazard. The presence of such distortions contribute to built-up of financial vulnerability, hinder growth of market solution for tackling risk, and complicate policy actions in events of crisis management. Progress in correcting these weakness however may be slow.