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6th December, 2008  Source:Asani Consulting

 
US Sub-prime Crisis - How much recession proof is the Indian Real Estate sector?

US Sub-prime Crisis
How much recession proof is the Indian Real Estate sector?
Asáni Consulting Private Limited
Dated: December 6, 2008

Last week, USA has been ‘officially’ declared to be in recession (since December 2007) by the National Bureau of Economic Research, the chief arbiter of US recessions. The sub-prime crisis and subsequent US real estate market crash triggered the current economic crisis, arguably the worst in history. A worldwide financial downturn was anticipated but the scale of damage was unfathomable. Globalization and financial interdependencies has spread the financial crisis across the world, and lately emerging economies like India and China are feeling the heat.

Declining industrial growth and consumption demand in India are strong indications of the global downturn creeping into the economy. The crisis, as it unfolds in the US, highlights some fundamental distinctions between the real estate markets of the US and India. These distinctions are important and had played a significant role in controlling the quantum of economic catastrophe in Indian real estate sector due to the instability in US economy. Therefore, it is important to recognize the unique characteristic of Indian markets to devise a policy prescription for the current economic troubles in India. Also, policy measures should not reflect too much caution, and impose unnecessary restrictions hurting the growth of the real estate sector in India.

Bank-based versus Market-based financing
India has a strong bank-based financing system; US and many other countries follow exchange-based financing system. The later implicitly promote risk due to the speculative nature of economic transactions in this system. Indian financial system and regulatory supervision acts as a strong immunity for the domestic economy from external shocks.

The case for volatile foreign investments
Indian real estate sector has been affected by the global financial turmoil for projects dependent on foreign investments. Also, additional investments in this sector have taken a hit. Foreign investments were mostly in the form of short term debts and equity exposures. FDI inflows [i] with long lock-in periods have escaped the downward market trend. The vulnerability of this sector is therefore due to its linkages to PE investments. Any panic selling by foreign investors takes the toll on the ‘value’ of realty funds in BSE and NSE, frontline trading exchanges of India [i] with long lock-in periods have escaped the downward market trend. The vulnerability of this sector is therefore due to its linkages to PE investments. Any panic selling by foreign investors takes the toll on the ‘value’ of realty funds in BSE and NSE, frontline trading exchanges of India [i] with long lock-in periods have escaped the downward market trend. The vulnerability of this sector is therefore due to its linkages to PE investments. Any panic selling by foreign investors takes the toll on the ‘value’ of realty funds in BSE and NSE, frontline trading exchanges of India [ii]. The declaration of the bankruptcy by the US operations of one of the leading US Investment Banks, Lehman Brothers sent the BSE Sensex crashing. Realty index was the biggest loser at 7.65 per cent, followed by IT index at 5.51 per cent.

Indian Banking: No breaking free
Some of the big financial institutions, banks and insurance companies in India are public sector undertakings. They carry a social responsibility and are regulated by government policy. Despite that, some public sector units remained competitive vis-à-vis the private sector in areas such as oil and natural gas, steel and are in sound financial condition. These institutions are examples of a balanced approach. This is unlike the American model of complete deregulation. At the heart of the crisis lies the US consumers’ unlimited access to credits in the housing market, owing to easier terms of lending (at sub-prime rates, or less than prevailing market rates). The Fed had to eventually bail out mortgage lenders Fannie Mae and Freddie Mac, in one of the largest bailouts in history. As guarantors of $5 trillion worth of home loans, they were the backbone of the US housing market.

Discrediting the Credit-worthy
Rash speculation in mortgage loans turned out to be death-knell for the US economy. Mortgage lending by US banks and financial institutions below sub-prime rates had created an artificial demand for houses there. Credit checks were compromised and new instruments were introduced to accommodate more customers without much credit worthiness. This became unsustainable when borrowers started to default on their repayments. A deluge of defaults wiped out the net worth of banks and financial institutions. Mortgage-backed securities were almost worthless as real estate prices crashed. Already with a huge debt and no money to pay it back, these financial institutions began to crumble, leading to the current meltdown.

Thankfully, Indian banks are not exposed to toxic array of financial assets like Western financial institutions. The mortgage market in India is much smaller than US; Mortgages as a percentage of GDP in India is still very low compared to other developed markets. Therefore, the exposure to mortgage risk is also low. Instead, the real estate in India has always been driven by real purchasing power. The IT and ITES sector has been the prime demand driver of the market, mainly for commercial and residential properties. The recent slowdown also has a lot to do with the slowdown in the IT sector. So the boom or downturn in India reflects real economic fundamentals instead of artificial financial interventions.

Market Maturity
Given the size of the US market the real estate crisis is deep rooted, manoeuvrability is low, and needs fundamental structural changes. Any intervention intended to correct the problem has long gestation periods for the market to react positively. India is a new market and evolving in many ways. There are many inadequacies in the sector and the Indian Government has been cautious with its policies for the sector. However, the slowdown in India can still be attributed as 'market corrections', more due to demand-supply factors. A correction in prices or interest rates will have some effect in pepping up the market.

The Social Context
Indian middle class led the real estate boom in the country [iii]. Rising income levels of a growing middle class along with increase in nuclear families, changing demographics of home buyers (the average age of a new homeowner in 2006 was 32 years compared with 45 years a decade ago), and easy housing finance has led to a boom in the housing sector. Despite the recent spurt in consumerism, Indian middle class values are conservative when it comes to exposure to debts. Investment in real estate is considered safe with high returns in the long run. This attitude towards investment has guarded against risk of default in loans that can lead to a US style mortgage crisis.



[i] ASSOCHAM. Share of real estate in total FDI inflows has been rising: From 4.5 per cent in FY 2003 to 25 per cent in FY 2006, to an estimated 26 per cent in FY2007. It is expected to touch $ 8-10 billion by FY 2010.

[ii] US-based funds flow tracker EPFR Global has released data which suggests that outflows from India-focused funds have abated for about a month. Year-till-date outflows from India-focused funds have remained at around $2 billion (Rs9,960 crore) since late October.

[iii] Almost 80 per cent of real estate developed in India is residential space, the rest comprise of offices, shopping malls, hotels and hospitals. According to the Tenth Five Year Plan, there is a shortage of 22.4 million dwelling units. Thus, over the next 10 to 15 years, 80 to 90 million housing dwelling units will have to be constructed with a majority of them catering to middle and lower income groups.
Keywords:Economic Slump, Financial Crisis
 
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