The problem is emanating from the reckless lending in the USA over decades, and especially in the residential mortgage market over the past 6-7 years that has brought severe strain to the global credit markets.
Real estate prices in the US had risen significantly in the last 15 years backed by some very lenient lending practices. This was all possible because such loans along with other types of debts were pooled and packaged into special vehicles (CDOs-Collateralised Debt Obligations) and sold globally to investors who were looking for higher yields against the backdrop of falling interest income from more traditional investment options such as debt issued by the US treasuries.
Simultaneously, as the mortgage boom was unfolding, most US investment banks had built a sizeable business of structuring and trading such mortgage loans. A typical balance sheet of a US investment bank is leveraged 25 times i.e. for every $1 in equity; they hold assets of about $25, the balance $24 being borrowed from markets.
The key challenge here is the willingness of lenders to finance these investment banks. The moment liquidity on the CDOs and similar instruments vanished, lenders to these institutions panicked as they felt that they would no be able to refinance their debt as most of the underlying collateral would be illiquid ( but not necessarily worthless).
This is where the US Fed stepped in and has created significant additional liquidity for several intermediaries apart from commercial banks, including investment banks and primary dealers. However, it came too late as the fifth largest investment bank in the US Bear Stearns got caught up in the rapid withdrawal of financing and was almost bankrupt as it has to be sold for 10% of its value to JP Morgan in a fire sale.
This has of course spooked investors globally and the panic is now well and truly on. The market doubts the Fed's ability to resolve this crisis. The market views this as an issue of solvency and not liquidity.
Back home, equity markets have taken a significant hit from their peak and the sensex is down 35% since the start of this year. Investors are wondering what happened to the decoupling and India stories?
In our view, not much has changed. When we talk about decoupling, we talk about economic decoupling which will be evident either way only over the next few quarters, Will businesses scale back their expansion plans or will consumers change their spending patterns.
While there may be an impact on the margins and in a few sectors, we believe that the Indian economy is largely insulated from events in the US. But if the credit crisis continues to grow larger (a small but not negligible probability) and global central banks are unable to turn things around, then we will also be surely affected.
Indian growth has largely been driven by an investment boom (through capex and infrastructure). Investment spending has been contributing about 35% to GDP growth (in China, the number has been almost 50% for many years).
Consumption should pick up due to short-term factors like the budget (IT cuts, excise/CST reduction, farm loan waiver etc.) and also the longer-term shift in demographics. These are unlikely to be affected in any meaningful way with what is currently happening in the US. Indian real estate.
A recent Knight Frank report says that notwithstanding the global uncertainties arising out of sub-prime meltdown, potential slowdown in US and weakening of the dollar, real estate demand in India across sectors remains strong.
According to a research report by JP Morgan, land deals in India are thriving and the total value of such deals, in the first three months of the current year have touched around Rs 23,000 crore, while another Rs 10,000-crore worth deals are in the pipeline.
Outlook
The repercussions of the US sub-prime crisis and the slowdown are sure to show up in the rest of the developing world. India is not likely to be any different. We have already seen some amount of rationalisation of real estate prices, particularly in the residential sector.
This is probably because of a combination of factors – decline in the purely speculative investments, high interest rate for home loans, and a glut of availability of units in some areas.
However, this rationalisation is not across-the-board phenomenon. We have, for instance, not witnessed any decrease in the prices of quality housing or in prime localities. Yes, the rate of capital appreciation may have come down of late. Transaction time also appears to have gone up.
This is because end users and the long-term investors tend to take a much longer time to decide. It is important to note that past four years have witnessed compounded annual appreciation of capital value of real estate properties by 40% and above in a large range of Tier I and II cities. In any structural bull market, such fast price appreciations are generally punctured by periods of price correction and/or consolidation. These phases are then followed by the next leg of the bull-run.
Notwithstanding some signs of growth softening in the recent past, even the most pessimistic observer also argues that the India economy is set to grow by the annual rate of at least 7-8% in the neat decade. By international as well as our own past standards, such growth rates are very high.
Along with high overall growth, the size of high and middle-income group population has exploded in India and their affordability levels have improved tremendously. The nationwide shortage in housing units is placed at a massive 20-25 million units. And the explosion in the IT/ITES sector will remain for a while.
And now more triggers such as the biotech, education, logistics and hospitality industries are waiting in the wings. These emerging sectors would be the new elements to make up the new economic boom. So in our opinion the real estate success story will continue for many more years to come. Even a modest correction in real estate prices would only increase the real estate demand going forward.
This is so because such corrections would delay/reduce the launch of new projects while the genuine buyer would not be able to infinitely postpone their housing demand in the expectation of a possible price correction. Simultaneously, slump in stock market, which has impacted fresh fund raising plans of real estate developers, has provided lucrative opportunities to other players like real estate funds.
Source: Economic Times