Japan, the US, Spain and Ireland are examples of high-profile countries whose economies were destabilised by a real estate bubble burst. How and why does real estate cause economic catastrophe?
Can it happen to India as well? The single common factor for real estate bubble burst across economies is the exposure of the banking sector to inflated asset prices. Economic collapse in all these countries has been led by the banking system. Japanese banks went through a painful period of restructuring in the 1990s while the US, Spanish and Irish banks had to be bailed out by the government. How does the banking system get affected by rising asset prices? Here is a simple example to demonstrate the impact of a real estate bubble burst on banks. Customer ‘A’ borrows Rs 80 from Bank ‘B’ to buy a flat worth Rs 100.
The value of the flat goes up to Rs 200. A goes to Bank B to borrow Rs 180 to buy another flat worth Rs 200. Bank B does not look at A’s income but looks at the value of the flat being pledged. So it lends Rs 180 to buy the second flat. Bank B has now lent Rs 80 + Rs 180 = Rs 260 to A. Bank B has collateral worth Rs 200 + Rs 200 = Rs 400 for the Rs 260 exposure to A. Now, the asset bubble bursts and value of the two flats that A owns drop by 50%, from Rs 400 to Rs 200. Bank B is now left holding collateral worth Rs 200 for loan of Rs 260 to A, who do not have enough income to service that big a loan. A defaults.
A real estate price correction could lead to more NPAs and this could lead to a self fulfilling cycle of a deep rooted correction in the economy. . A real estate price correction could lead to more NPAs and this could lead to a self fulfilling cycle of a deep rooted correction in the economy. In an era of sustained rise in real estate prices, A and Bank B transactions keep multiplying. Banks lend to builders to purchase land and construct buildings.
They also lend to non-banking financial companies, which in turn lend to both individuals and builders. In other words, banks have direct and indirect exposure to real estate. When the bubble bursts, they are left holding worthless piece of collateral. Banks fail leaving depositors in the lurch and the whole financial system collapses if the government and central bank do not step in and bail them out.
How are Indian banks placed in their exposure to the real estate sector? India has seen a ten-year period of rising real estate prices and the sector seems to be cooling off. Commercial property vacancies are 20 percent while residential inventories are rising every day with transactions down 50-60 percent. RBI data on banks as of end March 2013 reveals that banks have an exposure of Rs 1.26 lakh crore to commercial real estate, Rs 4.6 lakh crore to personal mortgages and Rs 2.67 lakh crore to the housing sector.
The NBFC sector, including the housing finance companies such as HDFC and LIC Housing Finance, would have an exposure of over Rs 3 lakh crore. Adding banks and NBFC exposure to real estate, the total exposure is around Rs 11.50 lakh crore. This works out to around 10 percent of GDP. Add to this the black money and unofficial lending that happen. The exposure just gets bigger. However, the economy will not collapse because of a deep correction in prices.
But that does not mean that a real estate price correction will not cause pain and suffering to the economy. Banks’ exposure to real estate is around 17 percent of total advances and if there is large-scale default in the sector, all lending will stop leading to strong downtrend in economic growth. Public sector banks gross NPAs (non-performing assets) as percentage of total advances is 4.75 percent as of March 2013 and has more that doubled over the last six years. A real estate price correction could lead to more NPAs and this could lead to a self fulfilling cycle of a deep rooted correction in the economy. It is best to prick the real estate bubble in India right now to avoid future calamity.
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