How The Domino Effect Works In Markets

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  • 07 Feb 2023

Financial markets today are closely interlinked and driven by trust. So, when there is a trust deficit, fear takes over. In such times of crisis, investors make errors of judgement, only worsening the situation.

Let us find out how the domino theory applies to financial markets.

Domino effects can be small or big. You may have come across headlines like ‘US missiles hit Syrian base, oil price up’. How are US missile strikes in Syria responsible for a rise in fuel prices in India? Syria is a relatively small oil producer, but it remains an important nerve centre of the global oil market.

Since a major US military exercise in Syria can snowball into an armed skirmish involving multiple nations including Russia, oil traders react negatively whenever there are reports of missile attacks. Automatically, the price of crude rises, pushing up the price of the Indian basket of crude, which determines the retail-level price of petrol running your car in India. If there is a sustained increase in oil prices, that would be bad for a country like India, which imports over 80% of its total fuel requirements. Price rise, i.e. inflation, causes the central bank to hike interest rates, pushing up your loan EMIs.

But domino effects are not always negative. For instance, an anti-pollution drive in China can help Indian producers of commodities heave a sigh of relief.

On 15 September 2008, Lehman Brothers turned turtle. The fourth-largest US investment bank came to a screeching halt after a 158-year journey. A massive exodus of clients, a drastic fall in its stock price, and devaluation of assets by rating agencies were the results of something more sinister.

Lehman Brothers was one of the first Wall Street firms to move into mortgage origination business. This was a far cry from its staple investment bank business. By 2008, the company was effectively operating as a real estate hedge fund with very little capital and extremely high leverage.

After the fall of Lehman Brothers, the crisis developed into a full-blown international banking crisis. The event led to a global economic downturn, now called the ‘Great Recession’. This was followed by the European debt crisis. With banks asking regulators for help, investors began to panic. They withdrew funds from money market funds in droves, leading to massive selling of securities and freezing of financial systems. There were more sellers than buyers. Panic-stricken investors also transferred vast capital resources into stronger currencies.

Financial markets operate on trust. There is an implicit understanding that an institution borrowing money will honour the repayment agreement. So, when a default takes place, alarm bells start ringing. A small bank or financial institution defaulting on a loan may be a sporadic event, but when large corporations do that, markets can be unforgiving.

The global financial crisis triggered a liquidity super-cycle around the world. Money, among other things, chased assets worldwide, upping their prices. In recent years, fund flows have created new records.

Eager to de-risk the financial system, regulators have made it easier for non-banking financial companies (NBFCs) to do business while keeping banks under strict vigil. This has led to NBFCs starting to go for short-term borrowing to lend for the long term.

With their credit appetite growing, NBFCs have become a significant force in the financial landscape. But should a default-like situation or liquidity crisis appear, NBFCs would have a hard time borrowing money.

Once liquidity dries up, weaker NBFCs may find it difficult to finance their business. Consequently, their costs for borrowing fresh funds would rise, hitting profitability.

Investors may not wait for things to turn bad. Some investors may ask for debt to be repaid, or they may sell bonds in the open market to raise funds. Seasonally tight months can amplify the lack of liquidity effects. But during a panic situation, investors let their emotions run amok. As a result, businesses, irrespective of quality, are put into the same compartment. That is when markets crack and create a self-cycle of massive selling.

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