#Financial Markets
A central bank is often required to address a domino effect in the markets. In doing so, it must safeguard both the national interest and stabilise the global economy.
Key Takeaways
• A central bank is the primary financial institution of a country or a group of countries that overlooks the monetary policy of the region.
• A major challenge that the central banks are often called upon to manage is the domino effect in the markets.
• A central bank is required to serve both the national economic interest and stabilise the economy whenever a domino effect hits the market.
Have you ever wondered why every time a commercial bank fails, the government rushes the central bank to rescue the situation? Why is a central bank always called upon whenever inflation rises and interest rates surge? The role of central banks in containing crises in the markets can hardly be understated.
A central bank is the primary financial institution of a country or a group of countries that overlooks the monetary policy of the region. As the main authority on economic policy, a central bank issues the national or regional currency, regulates the banking sector of the region, and enforces policies to combat illegal practices such as money laundering.
In India, the Reserve Bank of India (RBI) acts as the central bank of the country. Similarly, the European Central Bank (ECB) is the central bank of the countries which make up the European Union. Central banks such as the RBI and the ECB have played a significant role in managing economic crises on several occasions in the past and continue to do so.
One such common phenomenon in the global markets is the domino effect that central banks often have to manage. In such a scenario, a spiralling chain of negative events can adversely affect the economy of a country and even the world. To manage such a crisis, central banks act in a coordinated manner so that they serve both the national economic interest and stabilise the global economy.
In you ask the meaning of domino effect, it can be defined as the cumulative effect in one market generated as a result of another event somewhere else and it goes on until it is controlled.
Let's have a close look at a few major domino effects in the global markets. If we go back to the stock market crash in 1987, also known as Black Monday, it is another prime example of the domino effect. The 1980s witnessed a long period of development amid a remarkable performance of the stock market in the United States. The bull run led to an astonishing rise in the prices of stocks which led to an over valuation of those stocks.
When the bubble eventually burst in the US in 1987, the Dow Jones Industrial average (DJIA) fell 22.6%. However, it didn’t stop there. Markets in Europe and Asia couldn’t escape the devastation, given how closely interlinked the global market is.
The Asian Financial Crisis in 1997 was also an instance of the domino effect. In this case, the Asian economies saw an extraordinary economic boom in late 1980s and early 1990s, riding on the wave of foreign capital inflow and export-led growth. Countries such as Thailand, Singapore, Malaysia, Indonesia and South Korea saw a growth of 8%-12% in their gross domestic products (GDPs) during those years.
But a decline in exports to the West, non-performing loans defaulting, and bank failures were a series of events that took place in 1997 due to a domino effect. In several countries, multiple banks, enterprises and financial institutions faced insolvency in the face of the crisis.
Another domino effect began when a rise in bond yields in Greece during 2012-14 led to a debt crisis across Europe. It took years for the Greek economy and the broader Eurozone economy to recover. The role of central banks such as the European Central Bank (ECB) and International Monetary Fund (IMF) via bailout loans to Greece was crucial in managing this domino effect.
In the cryptocurrency market, an example of the domino effect was the collapse of the entire market due to the hack on the Mt. Gox crypto exchange. Over 850,000 Bitcoin (BTC) units were lost during the hack and led to a major sell-off that sent the price of BTC plummeting by 50%.
The Wall Street crisis in 2008 due to the collapse of the Lehman Brothers led to a terrible domino effect. It led to a global financial crisis (GFC) for the next 2-3 years which hit the economies in countries as far as India.
The COVID-19 pandemic led to a global lockdown and businesses began shutting down across continents. The pandemic-led lockdown spiralled into an extraordinary domino effect in the markets globally. The pandemic led to an intense atmosphere of fear and uncertainty among the investors. As demand dwindled amid falling incomes and supply fell due to restrictions, it created a collapse of the global financial order.
The period witnessed mass unemployment, supply chain disruptions, falling demand and supply. The economic conditions deteriorated so much that we are yet to recover completely. In the US, the S&P index fell by over 34% from its peak in February 2020 to its low point in March 2020. Note that this is a general indictor of almost all the markets across the world.
These events are some of the major examples of the domino effect in the markets. However, there are more. One common domino effect is a regular phenomenon in the global market. Whenever there is a political crisis in the Gulf countries, the price of the crude oil goes up instantly.
You might wonder why a political crisis in one part of the world is affecting the price action of a crucial natural resource globally. But this is exactly what a domino effect does, and this is why it’s so critical to nip it in the bud. It happens because the Gulf is a provider of crude oil to large parts of the world. A political crisis there affects the supply chain of the resources and leads to a surge in the price of the crude oil.
Managing such crises is necessary for any central bank so that a country’s economy is well functioning. Such interventions of the central banks in recent years such as during the 2008 Wall Street crisis and the COVID-19 pandemic have been noteworthy and deserve our attention. During such episodes of domino effect, price disarray and difference between buyers and sellers are impaired and markets exhibit unstable dynamics.
Central banks have an enormous interest in the well-functioning of markets, especially those at the heart of the financial system. A crisis in the markets due to a domino effect has a direct impact on different aspects of a central bank’s policy, such as:
• Monetary policy, and
• Financial stability
The domino effect in financial markets can potentially disrupt the flow of credit into the economy, impacting market activity and price stability. Therefore, the central bank in any country assumes the primary role in addressing these concerns.
Central banks have employed two primary kinds of tools to remedy the domino effect in the markets:
• Lending activities, and
• Asset purchases.
Lending activities can be beneficial in addressing core market disarray caused by liquidity concerns which often lead to market spirals. They may be put in place using existing counterparties. Asset purchases can be more effective than lending loans in containing the domino effect in the markets caused by a range of factors.
Purchases not only provide liquidity but directly impact the markets. These actions contribute to handling price discovery breakdowns caused by information disarray. Asset purchases can also resolve dysfunction caused by balance sheet limits because they eliminate risks from market members’ balance sheets. Furthermore, they might be more tailored to specific market sectors.
Actions of the central bank to resolve dysfunction in the markets are expensive and may make the economic and financial systems, central banks, and government resources vulnerable to a variety of risks. An -dependence on the central bank has the potential to distort market mechanisms. Too much help on the part of the central bank may potentially sabotage central bank capital and taxpayer funds.
Independence of the central bank, on the other hand, maybe jeopardised, particularly in emerging market economies. Actions such as the purchase or lending against government debt often lead to speculations that a central bank’s policy decisions are unduly influenced by the government’s financing requirements. All these risks are generally higher for asset purchases than for lending operations.
To reduce the impact of the domino effect on the markets, central banks may be inclined to use their authority to grow their balance sheets and supply liquidity. However, such activities must not be a substitute for the primary responsibilities of market participants to manage their own risks, which should be reinforced by appropriate monetary regulation.
Here are a few crucial strategies for traders to navigate the domino effect in the markets:
• Sniff around and find out if a domino effect is hitting the markets and take your call whether you want to stay or exit your position.
• If you are rather adventurous, you can bet on the stocks which you believe are going to recover big time once the market gets back to its normal dynamics.
• However, invest only what you can afford to lose. It's advisable to exit your positions if you are heavily invested in the markets during the beginning of the crisis itself.
• If you end with losses during such a crisis, don’t panic. Instead, try to find out if you failed to follow the rules of trading strategy. However, it’s not always your fault.
• Know that a trading strategy is not wrong if it fails to resist a domino effect in the markets.
• It's never a bad move to withdraw from the markets for some time and not invest until the domino effect is addressed. Or only invest a modest amount of money.
Recommended Read: Stock Market Basics for New Investors
A domino effect is the cumulative effect generated due to an event affecting a series of similar or related events. It is a type of chain reaction.
In the markets, a domino effect is the cumulative effect in one market generated as a result of another event somewhere else and it goes on until it is controlled. For instance, a disturbance in the Middle East often leads to a volatile price movement of crude oil globally.
The global markets are rife with several instances of domino effect:
• The Wall Street crisis in 2008 is a classic example of domino effect in the markets as it was caused by the collapse of the Lehman Brothers. The phenomenon led to a global financial crisis for the next 2-3 years which hit the economies in countries as far as India.
• Another domino effect began when a rise in bond yields in Greece during 2012-14 led to a debt crisis across Europe. It took years for the Greek economy and the broader Eurozone economy to recover.
In both these circumstances, both national central banks and international financial institutions has to intervene to combat the crises.
Domino effect, in most circumstances, is very bad for the economy as it leads to unpredictability and volatility in the global markets.
A central bank deploys primarily two kinds of tools to address a domino effect in the markets:
• Lending activities address the disarray caused by illiquidity generated by domino effect. These activities are executed using existing counterparties.
• Asset purchases are also effective in combating domino effect by infusing liquidity in the markets.
Nonetheless, it is understood that central banks should refrain from intervening too much in the market as stakeholders themselves should operate as per the nature of the market.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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