A bricks & mortar economy

It is almost impossible to live in an Indian city right now and miss the obvious signs of the construction mania that has gripped the country.

There is a profusion of new residential towers, malls, office blocks and IT parks sprouting from the urban soil, like wild grass after the first rain. Our cityscapes are changing dramatically, thanks to the new piles of brick and mortar all around us. But do we realize that the building craze is altering our economic landscape as well?

Let’s start with the stock market. The DLF share will be open for trading soon—and that listing will change the very nature of the Indian stock market, perhaps making it more vulnerable to the inevitable cyclical swings in real estate prices, but also making its composition more reflective of the underlying economy.

Assuming that it commences trading at around its issue price, it is likely that DLF will command a market capitalization of Rs90,000 crore. There are already many other real estate developers listed in the stock market and there is a long line of wannabes who are planning to follow in DLF’s footsteps. It’s pretty clear that real estate, which was an investment minnow till just a couple of years ago, will now be one of the big blue whales in our stock market. Perhaps only oil and software will be bigger in terms of market value. Brokerage house CLSA was prescient when it said in an April 2006 research report that the DLF IPO would make India a property-driven stock market, like Hong Kong and Japan.

A few back-of-the-envelope calculations show that real estate and construction could account for around 5% of India’s total market capitalization a few months down the line, despite the recent cooling off of land prices and lower valuations of real-estate developers. Surprised? Actually, there is no need to be. It merely reflects a broader economic fact.

The Asia Development Outlook 2007 published by the Asian Development Bank (ADB) tips its hat, so to say, at the growing importance of construction in the Indian economy. The ADB has actually divided India’s GDP into four sectors, with construction joining the regular three (industry, agriculture and services). This is the first time that I have seen construction given independent billing in GDP data. ADB has also suggested that the construction boom has stimulated credit growth and demand for consumer durables. People borrow to buy houses and then borrow once again to buy televisions and washing machines for their new homes.

The fortunes of many other sectors—from banks to consumer durables to some capital goods—are now inexorably linked with those of the construction business.
Good news? Perhaps. But this also brings a new type of risk in the Indian economy—the risk of asset deflation.

To understand why, look at Hong Kong. This island city is woefully short of land, a fact that has made it an economy heavily dependent on the vagaries of land prices. They power a huge part of the city’s government revenue, personal wealth and bank credit. A sharp drop in land prices inevitably sends the island’s economy hurtling towards recession. Government tax revenues drop, people feel poorer because of lower home prices and cut back on spending, mortgage defaults create cracks in the banking system.
Sure, India is no Hong Kong. Our economy is far more varied. But a strong real estate component in our economy, stock markets and banking system does expose us to a milder version of Hong Kong’s problem.

Many Asian countries such as Thailand and Indonesia did suffer from asset deflation after the financial crisis of 1997, even though their economies were not as dependent on real estate as Hong Kong is. A fall in real estate prices in these countries sent stock markets on a tumble, piled up bad loans in banks and squeezed personal wealth and spending.

In short: while the construction mania we see around us is part of the very welcome attempt to rebuild India’s tattered infrastructure, it would be foolish to forget that real estate can be a macroeconomic risk. Remember: The International Monetary Fund has included it as one parameter in the financial soundness indicators that it launched in 2003.