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Author: 
Dr. Mohammed A. Ramady
Publication Date: 
Mon, 2007-11-19 03:00

Twenty years ago, in October 1987, a financial hurricane whipped through the world’s stock markets, causing the biggest single one day fall in the US Dow Jones Index, by 508 points to 1739, far bigger than any that had been seen in the greater 1929 Wall Street crash. Panic selling followed around the world, and all seemed lost. And yet, calm returned within a few months, with most markets recovering all their losses.

Many believed that computer-driven program trades were a major contributing factor to Black Monday 1987. Central bank action then, as now, was key to try and stem the panic, as in 1987 the world’s central banks moved fast to cut interest rates and help the stock markets to recovery.

However, it seems we are no safer today than we were in 1987, and history seems to repeat itself, even in the Gulf markets. Current Saudi market euphoria has taken the Tadawul Index from 7500 to over 9000 levels, or 20 percent in a few weeks, setting investor hopes alight.

Could Black Monday happen again? Left by themselves, sometimes markets create an unstoppable asset bubble which then bursts, triggered by one or more unrelated event. Nowadays, investors seem to be conditioned by expectations that governments and central banks would intervene with interest rate cuts at the first signs of serious financial upheavals.

But such interventions are ineffective in the long run, but markets seem to go on believing that it works and repeat their excesses in different cycles. They did in 1987, and in 1998, the year of the Asian currency crisis, Russia’s debt default and near collapse of Long Term Capital Management, the world’s biggest hedge fund. They seem to do so in 2007, with interest rate cuts by the US Federal Reserve of 0.5 and 0.25 percent. They did following the 9/11 events, which came at a time when the US economy was already weak after the busting of the dotcom bubble, but 9/11 overshadowed this.

Can Black Monday arrive again with a vengeance? There are several pressure points that could arise to give reality to this scenario. The first is a threat to the pace of globalization and economic growth, which can halt the pace of growth of some countries that have helped to power global markets in the past few years. The world is truly grateful for the scale of China and India’s industrialization and their pace of economic growth which continue to defy all expectations.

However, can such growth be sustained, especially by China, and what are the factors that can jeopardize this internally? The growing disparity in economic wealth between rural and urban China is beginning to be an issue hotly debated by the Chinese leadership, but this debate can point to either even more break-neck growth to spread economic wealth more evenly , or to a slowdown which could lead to economic and social discontent. China, growing at 10 percent-plus a year for the next 10 years or more is maybe achievable, but the Chinese economy will overheat at some stage.

The more immediate pressure point that could trigger a future crash would be a systematic crises in the financial system, and, despite central bank interventions and interest rate cuts, there are signs of controlled mild panic attacks in the global financial markets. The danger posed by the greater use of derivative products in today’s financial markets, without a due recognition of the inherent credit risks involved, has taken almost every financial player by surprise — whether they be central banks, financial institutions, or those guardians of — the rating agencies.

And what a carnage it has been on the financial markets over the past few weeks, following on from the sub-prime loan fiasco, with the scale of losses that have hit Wall Street, and spread to other financial centers, defying all belief, and reportedly exceeding half a trillion dollars and still counting. The reality of the situation is that most financial institutions have barely started to recognize what constitutes a lower, or fair value of their impaired portfolio of sub-prime assets. Have the lessons been learned then to avoid another Black Monday? Some feel that they have learned these lessons, and argue that the growth of the derivative industry and securitization packaging has had a two-fold effect. Firstly, financial crises, it is argued, will become less common, as financial institutions spread risk to those most able to bear them, such as the Citigroups, Barclays, Merrill Lynch’s, Morgan Stanley’s and UBS’s of this world. However, this makes financial crises, when they do occur, become more serious as frankly nobody knows fully where the risks are located in the financial system.

Secondly, if the world’s financial community now reacts to the credit crunch of 2007 by concluding that a disaster has been averted on the scale of Black Monday 1987, and that it will not happen again, because of central bank interest rate cuts support, then it is a false feeling indeed. As previous financial crises have taught us, the market crashes occur at moments of maximum market euphoria and a feeling that nothing can go wrong. Just ask those who were in the Saudi stock market in February 2006. Those that argue otherwise are shunned like lepers and doomsayers. The Saudi markets are once more seemingly on an upward drive, too fast again for the likings of some, given that the lessons of the massive 2006 crash, correction or whatever one likes to call it, have not been fully learned. Let’s hope that disaster does not strike once again at another peak in local market euphoria.

(Dr. Mohamed Ramady is visiting associate professor, Finance and Economics, King Fahd University of Petroleum and Mineral)

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