In 1962, Edward Lorenz, the renowned mathematician from Massachusetts Institute of Technology, published a paper on Deterministic Non-periodic Flow in the Journal of Atmospheric Sciences. His premise was simple. Lorenz believed that linear forecasting models are not successful in predicting weather, as atmospheric phenomena in themselves are non-linear and complex. Explaining his findings that even small changes in the initial conditions could result in large changes in later states of a complex system, he gave a talk on ‘Does The Flap Of A Butterfly’s Wings In Brazil Set Off A Tornado In Texas?’ in which he discussed what is today commonly known as the Butterfly Effect.
The inter-connectedness of global investment markets was evident in the slowdown during 2008, when the contagion of the recession spread rapidly across the world. A financial pandemic of such scale had not been witnessed since 1929, nearly eight decades ago. In 2009, markets rallied to regain some of the lost levels. However, the world still pondered whether it was a bear market rally, a sort of dead cat bounce. Postulations on recovery since the global financial crisis have covered quite a few alphabets – V, U, L or W, with a possible ‘double-dip’ dominating the jargon of economists, policy makers and researchers.
Since 2009, several events have brought the world closer to the clock – the likely default by Dubai World in December 2009, news of debt concealment by Greece in early 2010, sovereign debt crisis in the PIGS (Portugal, Italy, Greece and Spain) nations and the debt downgrade of the USA in 2011. To onlookers, these do not seem like “black swans” anymore. These recent events have been watched anxiously, and even anticipated, with the complex network of world finance putting checks and balances to firewall itself from the impending crisis.
As per the International Monetary Fund, Greece contributed only 0.5% of the world’s GDP in 2010. Most agree that if measures of restructuring and bailout fail, Greece might eventually default, also leading to its eviction from the Eurozone by end of the year. What is linked to a credit event such as this is the likely contagion that would spread to other vulnerable sovereign states, the foremost being Italy, which is the third largest economy in the Eurozone and has a total debt of nearly 1.9 trillion euros. This will have a debilitating effect on the integration of Europe that the member countries have been aiming for. Demand in European nations will contract as they get drawn inwards, focus on their own backyard and put austerity measures in place, at least for the time being.
Political instability might manifest as citizens oppose austerity and elect a populist government. The troubles with Greece and Italy would not remain economic, but encompass a larger political gambit. The truth is, as Dani Rodrik writes – “Europe’s single market has taken shape much faster than Europe’s political community has; economic integration has leaped ahead of political integration.”
With all this happening in Europe, a variant of the Lorenz question arises: “Does The Flap Of A Butterfly’s Wings In Europe Set Off A Tornado In Indian Real Estate?” Indian real estate, as was witnessed in 2008-09, is not ‘decoupled’ from global events. Despite the fact that India’s GDP grew by 6.7% in 2009, rents of office and retail space fell by 40%-50% and absorption of office space fell by over 40% from 33.1 million sq ft in 2008 to 19.6 million sq ft in 2009. A confluence of global events, high deficits and stagnation in the residential sector might lead to a difficult 2012 for the real estate industry in India.
- Nearly 50% of the demand for investment grade office space in India is contributed by the Information Technology (IT/ITeS) sector. Over 80-90% of the revenues of the IT & BPO sector come from North America and Europe, which are the worst affected in the current sovereign debt crisis.
- Over 70% of the demand for investment grade office space in India is contributed by firms which are headquartered abroad. Many of them thrive on domestic demand; however, severe demand contraction in their parent countries will definitely push them to exercise caution.
- India’s high twin deficit of fiscal and current account is not only a threat to its growth, but has also reduced its ammunition for facing a possible contraction of demand from foreign countries.
- The residential sector showed resilience and recovered quickly after staying at the bottom for just 6-9 months. However, the rapid increase in prices and monetary tightening by the Government has led to stagnation in prime residential markets, which is faced by slowing sale velocities and fewer housing launches in the metropolitan cities. Having leveraged themselves extensively, developers cannot rely on sales from residential to sail them through this time around if demand contracts in the office sector.
However, there are certain upsides to the downside as well.
- While absorption levels improved in 2010 to regain those witnessed in 2008, the supply overhang ensured that vacancy rises and rents remain stable. Hence, the downside risk remains muted, as rents are already at their cyclical lows across most active markets.
- Short term devaluation of the Indian Rupee has made Indian exports more attractive and should help the IT/ITeS industry over the next 6-9 months. It will also make Foreign Direct Investments in India cheaper. However, it will nullify the effect of expected decline in oil prices, which could have helped domestic inflationary concerns somewhat.
- The Reserve Bank of India has always been a very conservative regulator, which is evident from the monetary tightening during 2010-2011. It has enough headway to infuse liquidity by cutting interest rates, which will directly benefit the residential sector.
The 2008 crisis is so fresh in public memory that a collaborative effort is visible in the attitude of Governments worldwide. Policymakers are tactfully taking steps to prevent a Lehman-scale bankruptcy situation. Only time will tell if this collective wisdom and awareness can change those initial conditions of the Lorenz Curve that can alter its eventual shape. For now, the attitude to maintain going forward is caution.
The author, Himadri Mayank is Senior Manager – Research & Real Estate Intelligence, Jones Lang LaSalle India
