The volatility in emerging markets has abated a bit, but may resume in the fallout of the Russian takeover of the Crimea. The capital outflows and currency depreciations experienced in some emerging market nations have been attributed to their choice of policies. But their economic situations reflect the domestic impact of capital inflows as well as their macroeconomic policies.

 Fernanda Nechio of the Federal Reserve Bank of San Francisco, for example, shows that exchange rate depreciations of emerging markets are linked to their fiscal and current account balances, with larger depreciations occurring in those countries such as Brazil and India with deficits in both balances. Kristin Forbes of MIT’s Sloan School also draws attention to the connection between the extent of the currency depreciations and the corresponding current account deficits. Nechio and Forbes both advise policymakers in emerging markets to make sound policy choices to avoid further volatility.

Good advice! But Stijn Claessens of the IMF and Swati Ghosh of the World Bank have pointed out in the World Bank’s Dealing with the Challenges of Macro Financial Linkages in Emerging Markets that capital flows can exacerbate prevailing economic trends. Relatively large capital inflows to emerging markets (“surges”) tend to take the form of bank and portfolio debt, which contribute to increased domestic bank lending and domestic credit. Claessens and Ghosh write (p.108) that “…large inflows in net terms are the financial counterpart to the savings and investment decisions in the country and affect the exchange rate, inflation, and current account positions.” They also endanger the stability of the financial system as bank balance sheets expand and lending standards deteriorate. These financial flows contribute to increases in asset prices and further credit extension until some domestic or foreign shock leads to an economic and financial downturn.

Are the authorities helpless to do anything? Claessens and Ghosh list policies that may reduce macro vulnerability, which include exchange rate appreciation, monetary and fiscal policy tightening, and the use of capital controls. They also mention, as do the authors of the other chapters of the World Bank volume, the use of macro prudential policies (MaPPs) aimed at financial institutions and borrowers. But they admit that the evidence on the effectiveness of the MaPPs is limited.

Moreover, the macroeconomic policies they enumerate may not be sufficient to deal with the impact of capital inflows. Tightening monetary policy can draw more foreign capital. Fiscal policy is not a nimble policy lever, and usually operates with a lag

What about the use of flexible exchange rates as a buffer against foreign shocks? Emerging market policymakers have been reluctant to fully embrace flexible rates. More importantly, as pointed out here, it is not clear that flexible rates provide the protection that the theory of the “trilemma” suggests it does. Hélène Rey of the London Business School claimed last summer that there fluctuating exchange rates cannot insulate economics from global financial cycles in capital flows and credit growth. Macroprudential measures such as higher leverage ratios are needed, and the use of capital controls should be considered.

Last week we learned that capital flows to developing countries fell in February, with syndicated bank lending falling to its lowest level since 2005. This was followed by the news that domestic credit growth is falling in many emerging markets, including Brazil and Indonesia. The ensuing changes in fundamentals in these countries may or may not alleviate further depreciation pressures. But they will reflect the procyclical linkage of capital flows and domestic credit growth as much as wise policy choices. And there is no guarantee that the reversals will not overshoot and bring about a new set of troubles. The waves of capital can be as tricky to ride as are ocean waves.