Game Over

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The rate at which Indian movies are grossing over Rs 100 crore seems too good to be true. With sufficient hype and buzz, even an average movie can now break records at the box office. It now appears that real estate developers in India, too, have taken a leaf out of the Bollywood trade. New projects see plenty of hype created by an army of brokers, front-page advertisements in national dailies, sales offers around the festive season, project tours by invitation and pre-launch discounts to attract gullible investors, while keeping genuine buyers away.

Favourable demographics, acute shortage of housing, easy credit conditions and high velocity of illicit money in the economy over the last few years have made real estate one of the most preferred assets in India. This consensus trade is also supported by other factors such as high inflation, negative returns on fixed deposits, chequered performance of equities, and the ease of investing unaccounted wealth in real estate. The crescendo that real estate as an asset class will generate positive returns under any economic condition has become louder day by day.

Soaring property prices have dominated social conversations all around. A recent survey by Assocham reveals that 82% of Indian youth see real estate as one of the safest and preferred investment avenues. Real estate prices follow an amplification mechanism, whereby a large increase in asset price is followed by higher demand, as investors think further price increases will follow.

Today, Indian real estate is among the most expensive in comparison to cross-country per capita income. However, a host of factors are converging after a decade, setting the stage for a deep correction in the Indian real estate market. The end of the Reserve Bank of India’s (RBI) expansionary monetary policy has begun: the trinity of 5% fiscal deficit, current account deficit (CAD) and GDP growth ensures a downward cycle of property prices.

Fuelling the boom

Let us examine the factors that have aided soaring real estate prices in India. We all are obsessed with quantitative easing (QE) in the West. However, QE in the form of open market operations (OMO) by the RBI has gone unnoticed in India. The liquidity was diverted to domestic markets instead of being used in building forex reserves. Excess liquidity, a double-edged sword, has two outcomes — runaway inflation and a depreciating currency. We estimate that a total of $175 billion worth of additional liquidity came into the banking system between 2008 and 2013. This resulted in money being funnelled into real estate over a period of time.

We have thus ushered in an era of low growth, high fiscal deficit and CAD, accompanied by lower investments by the private sector and declining affordability for Indians. Years of misallocation of the country’s resources, disguised as measures for uplifting the poor, have created a persistently high fiscal deficit, an irreversible process. Today, subsidies account for 42% of India’s gross fiscal deficit, exactly double from a decade ago. Consumption-oriented policies such as farm loan waivers, pay hikes for government employees, MGNREGA and the new Food Security Bill have ensured that subsidies will continue to remain high, making fiscal consolidation appear a very distant dream.

To finance the ever-increasing CAD, the central bank has accumulated external debt of $390 billion against forex reserves of $280 billion during this period. The depreciation of the Indian rupee causes more harm due to negative revaluation and interest outflow. Today, because of rising US bond yields and declining attractiveness of the Indian economy, the RBI is forced to make a U-turn on its expansionary policy in order to stem outflow of short-term debt and attract further capital. The withdrawal of liquidity from domestic markets is an irreversible process if authorities wish to restrict further depreciation of the rupee and signal that interest rates will remain high till exports recover and correct the deficit. The withdrawal of liquidity by the policy market will lead to fall in real estate prices.
Another important trigger for the fall in property prices is the start of the deleveraging cycle by the Indian banking sector, which is running a high investment-to-deposit ratio of 108% for decades now. The reversal of the easy business cycle, scarcity of capital and tight monetary cycle in domestic and international markets will force banks to deleverage their balance sheets over the next three to four years. One can observe the same scenario witnessed during 1997-2003, when deleveraging by the Indian banking sector was accompanied by deleveraging by corporates that had accumulated huge debts on their books during good times. Let me remind readers that the previous deleveraging cycle (1997-2003) witnessed price correction by more than 50% in Mumbai Metropolitan Region (MMR) property. Now, 2013 could mark the beginning of outflow of money from this sector.

The high structural growth story of India attracted much private equity capital in real estate between 2006 and 2012. Close to $20 billion of inflow came into real estate and construction businesses. This was used to fuel real estate prices by creating a stock of inventory, diverting money to other projects and investing to create land banks for future projects. In fact, real estate prices soared during this period, defeating the very purpose of allowing FDI in the sector to make housing affordable to Indians. However, with the average life of a private equity fund being seven to eight years, 2013 marks the beginning of private equity returning to its shores. The unique attributes of real estate investing make it a preferred choice for parking illicit wealth in India. According to various estimates, elections for the central government can cost upwards of $5-6 billion, while elections for state governments cost around $1 billion. With impending central and state elections in 10 states estimated to cost around $15 billion, money should flow out of real estate over the next 18 months to fund these polls.

Radical solutions

The government needs to seriously analyse its approach towards making housing affordable for the average Indian. The slow growth of personal disposable income over the past few years in comparison to GDP growth is testimony to the affordability challenge. Government records suggest there are only 35 million taxpayers — around 3% of India’s population — in our billion-strong country, with 1.5 million declaring annual earnings of more than Rs 10 lakh. A recent report by Cushman & Wakefield, however, suggests that more than 30% of the apartments under construction in Mumbai currently are priced at over Rs 1 crore each. This clearly indicates that wealth is quite concentrated among Indians, and tax evasion is rampant. Current real estate prices represent affordability for very few, while the average user has to part with 20 years of future earnings to buy a house.

Measures taken by the Chinese and Singapore governments to restrict price expansion in the housing sector, such as reducing the loan-to-value (LTV) ratio for a second home, taxation on profits from the second home and differential rates of interest for mortgages, should serve as guiding indicators for India. The time has come to deflate this bubble in a structured manner to save financial institutions and households and to channelise public resources into more productive use. If we fail to do so, the financial consequences can be quite dangerous.

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