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Impact Of The Current Crisis On India


This study endeavors to evaluate the extent to which the Indian real estate has been affected by the financial crisis that has enveloped the entire world. This chapter of the study attempts to understand how the financial crisis emerged to devour the global economy, with special emphasis on its impact on the Indian economy. The initial portion of this segment gives details about the financial crisis worldwide, and then explains its effect in the Indian context and for other countries. Finally, the impact of this crisis on the Indian real estate industry will be discussed in the last part of the literature review.

Global Financial Crisis

GECRS (2009) said that this is a tough time for the entire world, but particularly for the developed countries. Officially, the advanced nations are going through a period of recession, with negative growth in the two consecutive quarters of the year. There is no knowing the duration or the extent of recession. However, it is being considered the most awful period of recession ever since the Second World War ended (Reinhart and Rogoff, 2007).

There is no way that the developing nations could have escaped the fury of the crisis. These countries have also indicated slowdown in growth as can be seen from the growth rate of India’s economy during the year 2008-09, which was 6.7% as against 9% in the previous year (Acharya, 2009). The forecast for 2009-10 also appears to be grim (Acharya, 2009). Although the full impact of the global recession was not felt during the first six months of the year 2008-09, the impact on the economy is visible during the entire current year. Clearly, globalization is no more partial to prosperity than to poverty. In other words, it works equally potently for prosperity and deprivation.

About two years ago, according to OECD (2010), the sub-prime mortgage crisis erupted in the U.S. and spread all over to create an international crisis. Increase in the rates of interest and the falling prices of homes led to a surge of foreclosures and defaults. The crisis in the mortgage market would not have consumed entire economies had it not been for the fact that sub-prime mortgages were packaged and marketed as negotiable securities and ranked as investments. The securities became useless when their asset value became uncertain. It became difficult to evaluate them, and consequently, it began to hurt the interests of the various investor institutions. These financial institutions were not from USA alone, but also involved financial institutions from Europe and to some extent from East Asian countries (Foster and Magdoff, 2009). The financial system went into a tailspin when some of the leading institutions like Lehman Brothers went bankrupt. The misgivings about financial institutions caused overnight drying up of several markets like the inter-bank market. There is widespread belief that it was imprudent to let the Lehman Brothers fail. As a result of the crash of the financial system, crisis has gripped the reality sector significantly.

Regulatory Failure

According to Matthew Bender (2009) a significant aspect that emerges from the entire setback points to the failure of the regulatory authorities. Regulatory fiasco indicated two levels of failure. First, it clearly indicates that the financial system was not comprehensive enough to regulate all aspects of financial transactions, thereby creating a situation of “regulatory arbitrage”, wherein the unregulated segments were attracting the bulk of funds.

Second, crisis highlights the failure to understand the nature and working of the different derivative products (Matthew Bender, 2009). It is imperative to understand that derivatives are the natural outcomes of any financial process because they emerge as a result of a recognized need. Nevertheless, it becomes an alarming situation if it is impossible to read the risk factors in the derivative products. The present crisis presented the Rating Agencies as being responsible for showing the shady derivative products in bright light. There is evidence that there was a huge gap between innovative financial products and monitoring system of the regulators. That crisis erupted at a time when discussions for establishing an ironclad regulatory structure were in full swing at Basle and elsewhere (Reinhart and Rogoff, 2008).

Immediate Tasks

Read (2009) opined that the authorities in advanced countries are now faced with two-fold task for dealing with the crisis immediately. The first task is to set the financial system in order and the second task is to maintain a sufficient level of demand to boost the real estate sector. Considering that entire economy is being held to ransom by the financial system, the first step would be to set right the inefficiencies of the financial system and this can be done in many ways (IMF, 2009). Important financial institutions, whose assets can not be realized easily, are being provided liquidity. The Federal Reserve in the U.S. has brought down the policy rate to approximately zero. The economy is also being flush by large doses of liquidity. As a result, balance sheet of the Federal Reserve indicates that it has grown from 900 billion dollars to over 2.2 trillion dollars (Matthew Bender, 2009). Capital is being pumped into banks and other financial institutions from the recovery package of $700 billion announced by the U.S. Congress (OECD, 2010). There was initial apprehension that the funds from the package would be diverted to save the distressed assets. However, there is an actual Geithner proposal which is meant for purchasing such assets also, since there is widespread belief that this would help to revive markets like reality. Definitely, the U.S. economy requires a huge revival package to invigorate it. The U.S. Congress has implemented a direct Keynesian principle by agreeing to inject a stimulus package were $800 billion (OECD, 2010).

Medium Term Concerns

Aspects requiring immediate attention notwithstanding, there are medium term issues that need to be addressed (Zandi, 2009). It is evident that much of the financial crisis emerged as a consequence of intensely low interest rates and there can be adverse outcomes of pegging the interest rates below sustainable levels. There have been many years of current account deficits in the U.S. and the analysts believe that this leads to the situation becoming precarious. However, these concerns have been disregarded by the authorities who believed that U.S. was the preferred investment destination (Shiller, 2008). It must be noted that loss of confidence even in one situation can have adverse consequences over a long period of time. It is important for the U.S. authorities to carefully consider this aspect. Other aspect that needs careful consideration is the issue of leverage. In the U.S., there is a net borrowing pattern in all sectors of the society including households (IMF, 2007). Clearly, highly leveraged institutions were the ones who were in the most trouble during the crisis. The savings rate per household is rather negligible. While in a globalised system, the savings rate is not the sole determinant of the rate of investment, yet the policymakers and the regulatory authorities must carefully consider the issue of leverage in order to maintain financial stability (OECD, 2010).

The Impact of the Current Crisis on the Developing World

According to Denoon (200), it is evident from the pattern of the past few months that financial crisis in the industrially advanced countries leaves an indelible mark on the developing countries too. Stock markets in the emerging countries have indicated similar tosses and turns as the markets in Europe and New York, much like the behavior seen in the stock markets during the earlier international financial crisis of 1929/30 or the Great Depression. There is clear evidence of credit squeeze and intense reduction in the inter-bank lending in even those developing economies which were considered fundamentally strong and where the policymakers believed that they could prevent the global events to suffocate their economies (Downs, 2009).

Brownell and Brownell (2009) wrote that the liberalisation policies sweeping the developing countries are to be blamed for the immediate onslaught of crisis in the developing world, since the capital markets have become more contiguous, thereby creating newer ways of spreading the financial malaise. It must, however, be noted that this is just one of the ways in which the global financial crisis can impact the economies of the developing countries.

Reddy (2010) opined that the medium-term impact of such prices can be felt on the capital flows of the private sector into the developing countries, which is likely to dry up on account of credit squeeze and poor outlook of the investors for risk taking. The total private capital flows into the developing countries during the five years prior to the financial crisis have been extraordinarily high (Downs, 2009). It is interesting to note that the actual transfer of financial resources did not take place, since the developing countries were more inclined to create reserves of foreign exchange than utilize the capital. This created an unparalleled counter-flow of the funds from the developing countries to the advanced countries through central bank investments to create safe assets and independent wealth funds for the developing countries. This process completely broke the myth that capital flows from the rich to poor countries in free capital markets (Downs, 2009).

In any case, according to Zandi (2009), it is bad news as far as developing countries are concerned if capital inflow is reduced. However, this notion was falsified, considering that the developing countries were not using the capital inflows prior to the financial crisis for productive investment. On the other hand, as noticed by IMF (2009), the decision to build external reserves (indicating that the developing countries were using the external reserve to build a buffer which would keep their exchange rate suppressed in times of crisis) became counterproductive for the developing countries considering the interest rate differentials and unutilized resources. There is no doubt that some of the developing countries would have been badly hit by the reduced capital inflows, but for others it became a mixed blessing since it eliminated the pressure to raise the exchange rates, and therefore stressed on the amassing of domestic resources (OECD, 2010).

In the same sense, crisis tends to lessen the flow of official largesse to the emerging countries (Reddy, 2010). It has been well established that ‘financial aid’ from the developed countries to the poor nations is severely downgraded in case of any downturn in their own economy (Soros, 2009). Downturn apart, financial aid to the developing countries has shrunk over the past twenty years or so, even when it was boom time. The truth is that the developed countries have always been rather tightfisted even when offering debt relief to the countries which were forced to repay huge external debt at the cost of economic development. In spite of intense pressure from across the world to write off the debts of the developing countries, the efforts of G8 countries have been rather miserable (IMF, 2009). Even when small degree of relief has been offered, it has been accompanied by a number of damaging conditions and for creating their own public image. The world has noted with disgust the pace and degree of relief that the government of U.S. and other developed countries have provided to their own large banks who have shown irresponsible behavior.

A significant casualty of the crisis is the source of foreign exchange in the form of remittance income, particularly from employees based in developed countries (OECD, 2010). As it is, it has been estimated by the Inter-American Development Bank that it would be for the first time in 2008 that inward remittances will show a negative turn in the Caribbean and Latin American countries. Mexico is already experiencing a downturn in remittances (mainly from the workers settled in the U.S.), where the August estimates indicate a fall of 12% as compared to the previous year and it is expected that this trend is likely to continue (Read, 2009). The downward trend is afflicting many other countries whose economies depended heavily on the remittances like Bangladesh, the Philippines, Jordan, Lebanon and Ethiopia. As for India, the decline is anticipated considering that 50% of the inward remittances generate from the U.S. (Reddy, 2009)

Just like the case of remittances, exports of products and services are also going to be adversely affected by the international crisis (GECRS, 2009). The U.S. and the European countries are the most important export destinations for many developing countries, and as these countries move into an economic tailspin, exports to these markets will also fall. The widespread belief that China was emerging as the next economic superpower has crashed after the exports from China in the last quarter of 2008 declined massively and there was stagnation in the domestic manufacturing segment (Denoon, 2009). The economic growth of China has been predominantly export based, even though it has included other developing nation nations in its production chain. More than half of exports from China are targeted towards the U.S., Japan and EU. It is, therefore, not surprising that economic crash in these countries is likely to adversely affect the Chinese exports and other economic activity. Despite the enormous financial stimulus of 340 billion dollars over the next two years, which the Chinese policymakers hope will revive the domestic economy, it is unlikely that it can create sufficient demand which will cover the deficit caused by the recession in advanced countries (Denoon, 2009). On the other hand, the imports into China are too insignificant to stimulate the similar level of international growth.

Foster and Magdoff (2009) noticed that another casualty of the present crisis is the possibility of postponing or even canceling large investment projects across the developing world, if their viability is doubtful. This is likely to create a negative multiplier since cancellation of projects leads to job loss, which in turn suppresses demand (IMF, 2009). This has adversely affected the construction sector due to the cancellation of mega projects in the growing economies. A major shakeout is happening in the aviation industry, and in India this is evident from mergers and retrenchment of employees. Hospitality and tourism industry, a significant source of employment in many developing countries is undergoing a declining demand and cancellations in the upper end and middle class segments (Reddy, 2010).

The economic crash also busted the commodities bubble, thereby hurting the interests of those developing countries whose economy is depended on commodity exports, and bringing relief to the developing countries which imported commodities. This occurred after a period of unparalleled rise in the value of oil, petroleum and gases and other various merchandise which was brought about by speculative behavior of the investors. For instance, the world oil prices which had touched $150 per barrel in July 2008 crashed to less than $40.00 per barrel by December, while the Brent Crude futures came down to less than $70.00 per barrel (Zandi, 2009). The Reuters-Jefferies CRB index, which is an important index of commodity prices, indicated that prices in December were 50% less than the prices prevailing in July (IMF, 2009). It is clear that commodity markets became volatile on account of speculative behavior; although this trend is likely to continue as a result of economic crisis.

Acharya (2009) opined that this could mean a mixed blessing for those developing countries that rely on imports, particularly oil, since this will enable them to control the level of inflation. However, large numbers of developing countries are undergoing a food crisis which is not likely to get better any time soon given the economic scenario worldwide (OECD, 2010). This is notwithstanding the fact that prices of certain food items have come down, but they are still pegged much higher for the developing countries where per capita income is low and starvation is rampant. The financial crisis is likely to exaggerate the difficulties for poor countries, where the governments are hard pressed to ensure the adequate supply of commodities to meet the requirements of its people.

The impact of the economic crisis is likely to affect the developing countries, although the intensity of the impact will vary. The level of financial contamination and the likelihood of crisis in the domestic financial sector are incumbent upon the level of financial liberalization of that country. Huge external debts and deficit of the current account is likely to exacerbate the country’s problems. There are already indications that markets are anticipating a high possibility of default (in the form of the price of credit default swaps) by countries like Ukraine, Pakistan and Argentina, to the tune of something like 80 per cent or more (Denoon, 2009). This could be due to their banking system that is highly leveraged like in the case of Latvia or Kazakhstan. Countries like Hungary and Turkey have a huge deficit of the current account. In fact, countries like Indonesia, which have deregulated their financial markets along the U.S. model, have been the most adversely affected and their crisis may be worse on account of the crisis in their own markets. In contrast, according to IMF (2009), China has made it home and dry, largely because of the extensive state control over the banking system, thereby negating the impact of “innovations” in the financial market. India also has an extensive network of nationalized banks and a high degree of regulation, and therefore, is not as negatively affected as Indonesia. However, rising current account deficit and the economic reforms ushered in by the NDA and UPA in the face of protest from the Left parties has made the economy more vulnerable to global impacts as compared to China (Reddy, 2010).

Without any doubt, developing countries have a very meager contribution in the global crisis (OCED, 2010). However, the impact of this financial crisis resonated in the entire the world primarily because it erupted in the U.S., which is the hub of capitalism and which is powerful enough to thrust its economic policies over the entire world (Read, 2009). The intensity and the magnitude of the crisis indicate the shifting scenario of global economy which is likely to engulf the world in the coming decades. Such a state of economic helplessness in the world’s most dominant power is going to bring about long-term geopolitical swings. Huge bailout packages and government stimulus proposed by President Obama of the U.S. is likely to increase the volume of public debt in the country (IMF, 2009). As a result, it will not be easy for the country to maintain the military superpower status, which has since long propped the US dollar.

As the crisis is unfolding and there is no clarity about its final situation, it is clear that U.S. control over the world economy and politics has been shaken and which may have dealt the ultimate blow to the country. It is definite that days of linear and uni-directional control are over. Violent conflicts are going to arise for the control over scarce resources. However, it is clear that the new order global imperialism is gone forever. It is also clear that the mantra of neo-liberalism and the lofty proclamations that markets know best, or that financial regulations starts with self regulation hold no water. Ultimately, it stands to reason that more democratic and reformative options need to be explored because it is evident from the scale of the present crisis and its impact on the economies that the present fundamental economic model is not sustainable.

Impact of Financial Crisis on India

At the outset of the international crisis, the general perception in India was that its economy would not be swept in the storm blowing in the international economic landscape. However, the adverse effects of the crisis have been felt on the domestic financial sector as well as the balance of payments (Reddy, 2010). IMF (2009) noticed that the credit crunch that followed in the domestic banking sector has hurt the interests of medium and small scale enterprises by curtailing their access to credit facilities. The other macroeconomic implications of the financial crunch have been felt on prices, particularly the exchange rate. Apart from that, the direct and indirect impact on employment, especially the diminishing scope for employment in the export units has acted as a negative multiplier (IMF, 2009).

Reddy (2010) noticed that the self righteous and smug declarations of the Indian decision makers claiming credit for the growth rate of the Indian GDP (hiccups notwithstanding, it is still higher than the international standards) and pointing at the resilient financial sector of the country indicates their poverty of thinking. The government is probably afraid to accept the severity of the crisis and that its impact has been unexpectedly adverse on the employment sector, particularly export related. Nationalized banks being the backbone of the Indian banking system, domestic banking sector has been largely untouched by the crisis, all thanks to the efforts of the Left parties to prevent the government from privatizing this sector. Nevertheless, the inadequacy and vulnerability of the banking sector has been exposed through the inconsistent retail credit policies, efforts to package such debts as financial innovations, intense credit squeeze because of macroeconomic insecurities, lack of will or capability of extending the loans to small and medium scale enterprises except by way of personal credit (Reddy, 2010).

Soros (2009) opined that the global financial crisis has played out its impact on certain other macroeconomic factors. From the middle of last year onwards, there have been three situations which indicate the extent of economic descent: drop in the level of foreign exchange reserves with the Reserve Bank of India; rupee’s declining trade rate, specially against the powerful currencies like the U.S. dollar and the never ending falling stock market.

There has been a steady increase in the foreign exchange reserves since the past some years with the decline starting after June 2008 (OECD, 2010). It is evident that, unlike China, India as build-up of reserves was not indicative of its macroeconomic vigor, since this did not involve surpluses on current account. In fact, the inflow of foreign exchange was actually the FII investment by way of portfolio capital (Foster and Magdoff, 2009). Clearly, therefore, the buildup of reserves was largely due to the economic policies of the country that strove to keep the exchange rate under control so as to prevent the assimilation of such resources in the domestic economy. Understandably, these reserves being the result of hot money flows, it was only obvious that any form of decline in their respective economies would cause their flow to dry out, which is exactly what happened in the past some months ever since the economies of U.S. and other developed nations crashed (IMF, 2009).

The sudden breakdown of the rupee shook the confidence of the FIIs. The rupee continues its downward descent from Rs. 51 per dollar in March, 2009 (Reddy, 2010). The contention of some economists that depreciation of the rupee is a positive sign for boosting exports does not bring any cheer considering that the situation of trade in the international markets is not much to write home about. India’s liabilities include current account deficit involving a huge trade deficit and large overseas factor payments. Any fall in the value of the rupee indicates a quantum leap in the rupee value of factor payments (which include debt repayment and profit repatriation), which is bad news for many organizations and the balance of payments.

Reddy (2010) wrote that the feeling of dejection is compounded by the falling stock market indices. The first part of the year 2008 saw the Sensex at a historical high, as a sort of culmination of the mind-boggling growth of the past three years when its value became more than triple. The rise in inevitably followed by a fall and the decline has been so explosive that the level of Sensex fell even below the level reached in December, 2005. The patterns of growth and decline are visible in case of both. Definitely, FDI has indicated lesser fluctuations and greatest stability (even though it does include some portfolio-type investments that get categorized as foreign direct investment). FDI reached its highest in February, 2008, but since then it has been steadily declining, although it is still positive. The foreign investment trend, ever since the year 2008, which include portfolio investment (including both FII investment in the domestic share market and GDRs/ADRs) has been rather unpredictable and predominantly negative, implying net outflows (IMF, 2009).

Consequently, according to Reddy (2010), between May, 2008 and February, 2001, 24% fall was recorded in the total value of Indian equity being held by the FIIs. Certainly this is not caused by the change in the investors perceptions of Indian economic scenario because India still shows a higher GDP growth rate as compared to some of the other emerging and developed markets. The downward trend in FIIs is due to repatriation of the capital by the portfolio investors back into U.S. and other advanced countries. This move is not dictated by the concerns of safety since U.S. securities cannot be considered safe anymore, but to cut back on the losses arising from the crisis in the sub-prime mortgages and other commodities markets, and to beat the blues arising from credit crunch by maintaining certain amount of liquidity.

Regardless of the reasons, the domestic stock market has been hit very badly. The Indian stock market is not entrenched very deeply, and so FIIs hold a very strong impact on the stock market indexes, clearly underscoring the fact that the outward flow of capital can inevitably cause a fall in the stock market. Obviously, Sensex is mirroring the movement of FII inflows (The Financial Express, 2009). Considering the fact that the movement of FIIs has been more unpredictable and disturbing, it is clear that any stability in the market can be attributed only to the stabilizing role played by the domestic investors.

It is not surprising that the extent of external reserves is directly affected by the foreign investments flows which do not include only the FIIs also the direct investment. However, despite the synchronous movements of both elements, foreign investment has been less unpredictable as compared to the status of the reserves, indicating that balance of payments and other components, like external commercial borrowings, may have a significant role to play.

Furthermore, it would not be prudent to underestimate the effect of domestic investors transferring their funds. The rules pertaining to capital outflows have been liberalized and this has led to a significant outflow of funds from the domestic investors. Liberalization of dealings related to capital accounts by the Indian investors has added to the volatility that has resulted on account of India’s reliance on flow of foreign investment. It is imperative for corrective policies to address the issue of external payments (IMF, 2009).

Simultaneously, according to Reddy (2010), exports encountered a sharp decline of 17% in November, 2008 as against this same period in the previous year. Government and other analysts continue to present the revised projections about the overall growth because even though it was expected that the GDP growth rate would remain over 7% in the year 2008-09, it was expected to indicate a steep fall in the next year (OECD, 2010). The signs of employment sector being hit were visible as early as December, when it became evident that there had been a loss of more than 1 million jobs, particularly in the case of small scale exports manufacturing segments and construction sector (Reddy, 2010). Even agriculture aimed at producing crops meant for export encountered number of difficulties on account of the crashing prices, adding to the overall financial doom. As a result, employees in different industries and services have seen a real or sometimes nominal drop in their wages, as have the incomes of the self-employed people who count for practically 50% of the work force. Small manufacturers across the spectrum of industries have been squeezed by the declining demand and the credit crunch. In this scenario where banks are unwilling to extend credit to any and every borrower, lack of liquidity is causing the investment projects to be scrapped, while even those borrowers who are considered secure by the bankers are shuddering at the prospect of investing in times of uncertainty. Tax receipts by state governments have declined, causing them to be cash strapped and incapable of covering their basic expenses on essentials services, leave alone development (Reddy, 2010).

Booker (2009) noticed that the construction industry involves a large number of people but it cannot be over looked that the construction and real estate industry is has been the major hit of the worst economic crisis ever after the great depression has. It in no way means that the problem of providing affordable houses in towns and cities can be swept under the carpet. The basic problem has been that the focus of private developers has been to tap the luxury segment without dealing with the basic and elementary housing requirements (Agarwal and Range, 2009). Therefore, it is imperative to address the housing problems of the middle class, primarily through public sector undertakings through self-financing schemes.

Mercifully, according to Financial Express, (2009), the ‘distress’ or the ‘toxicity’ of the assets of the developed world do not directly affect the Indian financial system, since Indian banks do not have too many overseas branches. Nevertheless, the ‘decoupling’ theory does not stand true since the recessionary trends in the overseas markets have definitely hurt the economy in India.

IMF (2009) noticed that falling trade and capital flows represent the indirect impact. International commodity prices, particularly the price of crude oil, have had such a steep fall so as to reduce the import bill from the value estimated earlier on. Exports of goods and services have been blown away by the recessionary trends overseas and the overall growth of exports has declined in 2008-09. This in turn impacts the other export-oriented sectors, e.g. garments, gems and jewelry, and automobile components (Reddy, 2010).

On the other hand, 2007-08 experienced a huge inflow of more than 100 billion dollars, while 2008-09 witnessed only $10 billion net increase in the capital flow (OECD, 2010). Portfolio capital showed a negative trend and the Indian companies had tough time raising money in the overseas markets. Exchange rate had to bear the impact of all these factors.

The preceding portion of the study has given the details of the reasons why the Indian financial system was not affected to the same extent as the financial system in other countries. However, reserves fell on account of liquidity drying up. The Indian banks were hard pressed for credit on account of Indian companies finding it difficult to raise funds overseas, including trade credits (Roy and Bhoir, 2009). This must be seen as the backdrop for the Reserve Bank trying to enhance liquidity in the country. Some of the steps taken include reduction in the current credit ratio and repo rates as it is stated as the rate at which usually the banks inject in the money into the system whereas the reverse repo rates can be defined as the rate at which the private and the national banks try to book their surplus cash inflow with the RBI for a temporary phase [allbankingsolutions, 2010]. Nevertheless, RBI needs to be vigilant about the liquidity status and review its actions periodically. However the impact of the actions taken by RBI has not reach the ground level, probably because of sluggish growth in credit. It seems to be the case of ‘leaving the horse to the pond without being able to force it to drink’. Reserve Bank of India is entrusted with the task of rejuvenating the financial environment by extending credit where possible (Financial Express, 2009).

Impact of Financial Crisis on Real Estate Market

According to Renaud (2003) real estate prices went through a new low in the U.S. between 1996 and 2006. Recessionary trends began with the dot com bubble bursting in 2000 and the terror attacks of September 11, 2001. The Federal Reserve tried to boost liquidity by reducing the rate of interest from 6.5% to 1% in the year 2002 (Kallberg et al., 2002). The basic assumption that value of housing would always increase was based on the progressive trends in the previous five years, since housing was believed to be a safe investment. Declining interest rates provided cheaper loans and encouraged larger sections of the society to buy houses by taking mortgage loans. The increasing real estate prices also encourage the financial institutions and banks to view it favorably, since on account of any defaults by a borrower the bank could liquidate the mortgaged property. The banks sent caution to the winds by approving high interest loans for sub-prime borrowers with very low credit rating (Shiller, 2008).

According to Zandi (2009), demand for realty spiraled with sub-prime mortgages, adjustable-rate mortgages and interest only mortgages requiring just a nominal down payment. In turn, the demand pushed the prices of real estate even further till the prices became so high that it became unaffordable. However, the demand for real estate declined once the interest rates increase in 2007 (Reinhart and Rogoff, 2008). Disposable incomes in USA begin to decline as a result of reduction in the economic activity, which in turn suppressed the demand further. This was the end of the economic boom as far as American realty was concerned: supply exceeded demand leading to fall in prices. Recovery of loans from those who defaulted became difficult since the financial institutions could not sell the mortgage property because of depreciated prices.

According to Foster and Magdoff (2009), 25 sub-prime lenders announced their decision to declare themselves bankrupt, because of huge losses, and offered themselves for sale. Barring Goldman Sachs, all other banks listed on the Wall Street had no other options but to clear off their debts amounting to millions and trillions of dollars in loans by March 2008. The CEO of Citibank got his marching orders, JP Morgan Chase bought over Bear Stearns to prevent it from becoming bankrupt and, by the middle of 2009, UBS AG Swiss Bank announced a job cut of 5500 (Matthew Bender, 2009).

As per Brownell and Brownell (2008), USA saw its worst nightmare since the crisis in 1930s, when the first quarter of 2008 showed sales decreasing by 22% and the median price of a single family house down by 7.7%. Experts believe that this was not the case of nationwide economic bubble in the housing segment; it was more like number of small bubbles bursting in different states on the basis of differing prices. It was clear in May 2008 that 2/3 of all American cities were witnessing the crash in the housing segment.

The ensuing months saw the American economy sliding deeper into recession even though the Federal Reserve tried to stem the downward flow by reducing the interest rates. Nevertheless, markets all over the world were headed down accompanied by an intense credit crisis. Sensex too followed suit in India. Finance Minister P. Chidambaram believes that credit and financial flows in the country were only the modestly affected by the mortgage crisis, although the stock markets were responding to events unfolding in American and Asian markets (Financial Express, 2009).

It was widely speculated that the downturn would impact the Indian housing market, too. Jones Lang LaSalle Meghraj, a well known property consultant, released a report on 27 May, 2008 which stated that even though the Asia Pacific region had witnessed a direct commercial realty investment to the tune of $121 billion in the year 2007, which was 27% higher than the recorded value in 2006, there are indications that the sub-prime crisis will impact the mature real estate markets in 2008 (Business Line, 2009). In keeping with the trends elsewhere in Asia, Indian real estate market has encountered a downturn as a result of the sub-prime crisis.

Impact on Indian Real Estate Market

According to Agarwal and Range (2009), just before the credit crunch, the Indian real estate was witnessing a boom with a compelling demand. Office space was much in demand ever since 2001, and by 2006 the vacancy levels were as low as 2.9%. The prices of property were skyrocketing, to the extent that they were double or triple in certain areas, while real estate prices in Mumbai could compare with those in Manhattan. The Sensex indicated outstanding performance by the infrastructure stocks as compared to others between May 2003 and May 2006.

However, according to Zandi (2009), a number of American companies began to wind up their foreign operations or closing their outsourcing operations when the sub-prime crisis broke out. The bleak growth prospects of the American economy spread its gloom in India and the demand for office space began to dwindle. Seven major cities which faced the falling demand and volumes of supply caused a rise in the vacancy rate by anything like 9-13 percent (Business Line, 2009). It is not as if the Indian real estate market did not have its inherent problems, but the stunning growth in this sector prevented the focus on addressing these limitations. The crisis merely brought these weaknesses back into the limelight.

According to Downs (2009), delays in the completion of products, running into anything between 2 to 3 years, render it risky to invest in Indian real estate sector. It takes unusually long to acquire government approvals for the project and real estate developers in India are not exactly known for completing their products on time. Inadequate laws do not provide protection to investors in such situations. Furthermore, land being a state subject, policies and rules regarding real estate of different in different states and there is no provision of central registry for land deeds. Rampant corruption and poor infrastructure add to the woes of the real estate industry.

There has been no time as bad as the year 2008 for the Indian realty, with a 44% fall in BSE-Realty, while Sensex indicated a fall of 20% (Reddy, 2010). The downward trend in Indian real estate market has been the result of credit crunch worldwide, rising rates of interest and double digit inflation. Unitech and DLF, the two major realty players in India have seen their respective stocks deplete by 61% and 58% (Business Line, 2009).

Increasing prices of steel and cement, two important construction materials, have also put the interests of the real estate companies. The Wholesale Price Index (WPI) indicated a steep rise to 344.1 on 8 March 2008 from 287.4 on 1 March, 2008 in its iron and steel component (Agarwal and Range, 2009). The prices have risen on account of rising demand while there has been no new investment in the steel plants.

A raise of 50 basis points on the lending rate and CRR (Cash reserve ratio) by the Reserve Bank of India brought out a respective raise of 8.5% and 8.75% on each (Roy and Bhoir, 2009). Property companies borrow heavily to deal with their land development expenses and then the proceeds from the advance sales are used to repay the loans. Therefore expensive credit works to suppress the demand for real estate while increasing the cost of credit for the realty companies.

According to Business Line (2009), Office of the Economic Advisor, Government of India released provisional information about the rising inflation – it was 11.89% for the week ending June 28, 2008 – indicating that consumer spending has declined, thereby negatively affecting the purchase of residential property. Given this scenario in the different Indian markets, IPOs also do not seem to be viable for raising funds.

Since the start of the 2008, cost of construction has risen by 25-30% (Agarwal and Range, 2009). Buyers have been put off by the rising prices and interest rates and this has led to a massive buildup of inventory. July, 2008 found itself recording of 52 week low in the prices of stocks of realty companies. DLF stock prices have fallen 20% since July, 2008. This is despite the offer from the company to buy back its shares in a bid to pump up the stock value. Unitech declined 30.66%, IndiaBulls Real Estate by 34.1%, HDIL by 33.16%, Anant Raj by 30.16%, Akruti City by 22.11% and Phoenix Mill by 56.18% (Agarwal and Range, 2009).

Crisil reported that, in the coming months, liquidity crunch stares in the face of small and medium property developers as a result of decline in sales and increase in costs (Booker, 2009). Majority of the property developers have extensively borrowed in the last three years to expand their operations, and the downturn has now made them vulnerable to lower profits, lower liquidity and limited sources of funds.

In all, the scenario does not seem to be too rosy for the real estate sector in the near future. Experts believe that only if the prices of homes fall can the demand be raised to a level of creating stability in the property segment. However, the companies that manage to survive this slowdown would in the long term gain immensely when development and greater infrastructure will boost the prices of property. The long-term scenario for real estate industry does not seem to be too bad. There are all indications of continued development of the sector, particularly as a result of measures taken by the government for streamlining the process of acquisition and development of land in the country. Therefore, there are all the markings of a bull run in the real estate segment over the long run.

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