However, if the domestic financial system is underdeveloped and financial institutions are not adequately supervised, as external hot money increases the deposit base of domestic banks they may be lured into fueling domestic asset price bubbles. These have two major consequences. First, asset price inflation eventually leads to domestic inflation and erodes external competitiveness. Second, excessive lending concentration in real estate exposes financial institutions to large non-performing loans when oversupply of property emerges. Indeed, banks are absorbing credit risk on top of interest rate and exchange rate risks. In some Asian economies, weakness of the financial system has constrained the ability of the monetary authorities to raise interest rates to defend their currencies when the exchange rates are under pressure. Conversely, to allow the currency to depreciate exposes banks and other borrowers to exchange losses on their unhedged foreign currency liabilities. 26. At the same time, the external environment has been changing. Whilst Asia was enjoying an unprecedented boom, the global competitive environment was subtly but surely shifting, which led to portfolio rebalancing by global asset managers. The adjustments in the US economy, through fiscal and monetary tightening, and technology and corporate restructuring, had brought substantial benefits in the form of lower budget deficits, and the lowest levels of unemployment and inflation for decades. In case anyone forgets, the US equity market has in the last three years outperformed almost all Asian equity markets with the exception of that of China.
Il Sole 24 Ore: The EU plan to help Greece relies on bilateral aid from EMU countries and on the involvement of the International Monetary Fund. The ECB was clearly against the IMF participation. What do you make of the EU plan? Trichet: I was not against the IMF involvement in itself. I was against the involvement of the IMF alone. I have always been in favour of the maximum level of responsibility exerted by the governments of the euro area as is prescribed by the Stability and Growth Pact. The pact is at the very heart of EMU: it calls for member countries to assess and judge the fiscal policies of their peers; this peer’s surveillance can impose sanctions. In the days preceding the EU meetings, I called all governments to live up to their treaty responsibility and to the provisions of the Stability and Growth Pact which is essential for the EMU to function well. From this point of view, the declaration of the euro area Heads of State or Government is appropriate. It is also a good and workable solution. Il Sole 24 Ore: Do you expect it will be used? Trichet: At this moment in time I don’t expect this mechanism to be necessary. Greece should proceed with its recovery program in a very determined way as committed in front of the Eurogroup. Il Sole 24 Ore: Is a default of Greece a distinct possibility as some commentators seems to expect?