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Compared to the past crises, the EMEs, in general, are now resilient and in a better position to absorb a financial shock. They have developed resilience to shocks by improving their macroeconomic conditions and regulatory frameworks. EMEs have been achieving a healthy growth with more or less stable inflation and have reduced their dependence on external demand. There has also been an improvement in fiscal positions, supported by the development of domestic securities markets. The external debt burden has declined and the composition of financial flows has changed with lower reliance on borrowings from international banks.

Several EMEs have addressed the weaknesses that led to the earlier crisis by strengthening prudential regulation and supervision more in line with international best practices. Banks' balance sheets have improved and capital ratios have risen. Corporate governance practices have also improved. To the extent EMEs have introduced flexibility in their exchange rates, their vulnerability to external shocks has declined. All these factors have reduced the vulnerability of EMEs. Large reserves held by EMEs should also enable them to cope with the volatility arising out of a sudden shift in market sentiment.

While macroeconomic fundamentals of several EMEs are strong, placing them in a relatively better position to withstand deterioration in international financing conditions, economic performance of some EMEs has been found to be less robust. The conditions in these economies may get accentuated by adjustment of global financial imbalances and high and volatile oil prices. A possible volatility in the global financial markets emanating from a rise in interest rates could magnify and propagate the problems associated with less than satisfactory performance in some of the EMEs, making them vulnerable to sudden reassessment of country risk. Such threats are real as the default rates of sub-investment grade borrowers could increase. Credit derivatives, which have proliferated in recent years and whose pricing has depended on relatively untested models and default correlation assumptions, may in particular be vulnerable to corrections.

The main challenge for EMEs is to continue to take advantage of the current favourable external financing conditions and at the same time pursue domestic macroeconomic and structural reforms necessary for long-term stability. In fact, some EMEs have well-advanced external financing, in some cases even including prefinancing for 2006 . EMEs have made significant gains in terms of healthy growth, stable inflation, large trade surplus, greater exchange rate flexibility and lower debt burden. While EMEs are preparing themselves to face sudden shocks, efforts need to be made by all concerned for an orderly adjustment of global financial imbalances. While co-ordinated policy action would minimise the cost of rebalancing, perhaps, a stress testing by all the concerned regulators in the EMEs to assess the extent of the resilience could be helpful.

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