The Hindu Business Line : Black Monday revisited

The 1987 stock market crash was not followed by any Depression, as in 1929. That the market recovered quickly was attributed to the assurance of the Federal Reserve that it would stand by for any rescue act in case the payment mechanism broke down.

OCTOBER 19, 1987. I was on my way to Sydney as an Adviser to the Reserve Bank of India Governor, Mr R. N. Malhotra, at the 17th SEANZA Council of Governors' meeting hosted by the Reserve Bank of Australia (RBA). The meeting takes place every two years to plan the training programme for the senior staff of the central banks in South-East Asia, New Zealand and Australia. As I sat back comfortably, several thousand feet above, the financial ground below was quaking with tumultuous happenings in the leading stock markets across the globe.

My host Bill Norton, Head of the Financial Markets Group of the RBA, was one of the most harried officials in Sydney that day trying to deal with the cataclysmic happenings in the system. The Sydney market had fallen by 45 per cent — much more than the 22.6 per cent recorded earlier in New York, where it had all started. The Dow Jones Industrial Average fell 508.32 points and closed at a record low of 1,738.40. This day, now known to the world as Black Monday, is documented as the worst stock market crash in history with reverberations across continents. The 22.6 per cent fall in 1987 doubled the percentage lost in the crash of 1929, which ushered in the Great Depression.

In the US, Mr Alan Greenspan had taken over as the chief of the Federal Reserve System only two months earlier. He had to face the first of the three major crises in his office. The other two were the expectations of convulsions in the financial world on the eve of the new millennium because of a possible crash of computers and the 9/11 terrorist attack.

On every occasion he came out triumphant in preserving the stability of the system by just promising to be ready to meet all needs of liquidity. In fact, on the first occasion, he spurned the idea of closing down the markets, which the US President could order under a special dispensation.

Mr Greenspan issued a one-sentence statement in his name at 8.41 a.m. on Tuesday, October 20, before the markets opened: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system." The Federal Reserve Act provides for the central bank extending credit even to brokerage houses and other non-bank institutions.

The 1987 crash was not followed by any Depression, as in 1929. The market recovered quickly. Many attribute this outcome to the assurance of the Federal Reserve to stand by for any rescue act in case the payments mechanism broke down. With thousands of transactions running into billions of dollars waiting for settlement, any default would have had a domino effect.

The causes of the crash have been written about by many researchers. Some of them are: (1) According to the Brady Commission (also known as the Presidential Task Force on Market Mechanisms, which was appointed to investigate the causes of the crash), the failure of stock and derivatives markets to operate in sync. (2) Program trading. When the price of a stock falls below a preset level, a programmed computer automatically sells that stock. (3) Lack of liquidity; (4) Rise in treasury yields from 7.6 per cent at the beginning of the year to 10.0 per cent, providing an incentive to investors to sell shares to buy bonds; (4) High price-earnings ratio at 20; and (5) Wrong judgments of professionals in charge of portfolio insurance.

There is, however, a consensus that not one but a multitude of factors led to the crash. Perhaps, the flash-point was provided by the announcement of what was then the highest trade deficit of the US, followed by the statement of the then Treasury Secretary, Mr Howard Baker, that the dollar needed to depreciate to solve the problem. It led to a panic selling of dollar-denominated assets by foreign investors as a pre-emptive move.

Reforms were undertaken in the US to prevent future crashes. Circuit-breakers were installed to prevent extreme changes in the stock market. After the crash, systems and procedures were put in place to coordinate the activities of multifarious regulators and ensure communication between them and the markets. One of the revelations of the crisis was the fractured responsibility for the smooth running of the markets. There was no single authority to take the command position.

It is appropriate to ponder the recent developments in the Indian stock market on the occasion of the 18th anniversary of the Great Market Crash. With globalisation, trends in international markets are bound to have their effect on the Indian economy, as seen recently. The Mumbai market exploded a few weeks ago with the Sensex rising beyond expectations although it is now slowing down.

The Finance Minister, Mr P. Chidambaram, has assured the nation that there is no scam in the market, as it is well regulated but there could be some adventurous players. He should remember that, both in 1992 and 2000, two different adventurers brought down the Indian market with their scams. Share prices of nondescript small-cap companies reporting losses have gained considerably, leading to doubts that they could be vehicles for laundering money.

A few months ago, the RBI raised the minimum margin on bank advances against shares, guarantees, etc., to 50 per cent from 40 per cent after seeing the market zoom up. But since then, even as the Sensex reached stratospheric levels, it has not moved in the matter. Probably it is feeling comfortable that there is a stipulation on bank credit for share transactions not exceeding 5 per cent of total credit at the end of the previous year and that this would take care of the problem of possible misuse of funds.

Five per cent of total bank credit should be related to the average daily turnovers of the NSE and the BSE. The 5-per-cent ceiling may have been appropriate when it was introduced because credit transactions in the banking sector were not as large then as they are now.

After normal business, at the end of each SEANZA Governors' meeting, there is an exchange of views on current economic problems facing the world. Naturally, the market crash was the theme for the meeting in October 1987. Mr Malhotra pointed out that India was not affected because its markets were insulated from the rest of the world.

This escape route is no longer available to the country. Willy-nilly it is becoming a part of the global financial system. How would the country react to a crash of the magnitude of 1987 with repercussions on the value of the rupee also? As the US found in 1987, in India too the responsibility for the markets is fragmented. Systems should be in place for constant monitoring and coordination among not only the regulators but also the market-makers. The authorities need to develop contingency plans for various scenarios.

(The author is a former officer-in-charge in the Department of Economic Analysis and Policy of the RBI.)

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