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Sectors worst hit by Sub-prime crisis

Mr. Rahul Singh | Posted On Saturday, October 25,2008, 04:55 AM

Sectors worst hit by Sub-prime crisis



Some time back I wrote an article on Sum-prime crisis. Many users have requested me to write an article on how sub-prime crisis has/will affect our Indian economy. So the following piece of article will help you understand this issue.

As you may know sub-prime crisis is the ongoing financial crisis characterized by acute liquidity crunch in the global capital markets. At the core of this crisis lies “sub-prime housing loan market.” Due to this crisis, a large number of financial institutions either failed or merged with other institutions or requested US or European government to bail them out. One way to minimize their losses was to sell their short-term investments, which was either in their home country or in emerging markets (EMs) like India and China. Once they started selling their investments in EMs, markets in these economies crashed, as we saw in India where Sensex crashed from 21,000 levels to 10,000 levels. Let’s try to understand how it will affect us and our economy.

Stock market
Many of our readers have asked us to explain the concept of stock market and how it affects the stock and future prospects of a company. A stock market is a public market where stocks of companies are traded (buy/sell). There are over 2000 companies currently listed on BSE Sensex. Companies go public (i.e. list themselves on the stock exchange) to raise capital (money) for their operations and future growth plans. The stock price of a company generally reflects the growth potential of the firm, the industry it operates as well as the risk of their investments. The stock is an attractive currency for the firms in the bull market. Firms may sell (issue) these stocks in the market to raise capital to fund their expansion plan without the headache of interest payments that accompany debt. So any downward movement in the stock market might decrease the stock price of these firms and hence reduce their ability to raise sufficient capital.

A large number of financial institutions (Investment Banks, Mutual Funds and Hedge Funds) buy or sell these companies’ stocks on the exchange. Their demand for a particular stock or sector also helps to boost the stock prices. If these FIs start heavily selling their investments (lowering the demand) for one reason or other, it will negatively affect companies’ stock price. Apart from that some macroeconomic factors such as inflation and recession also affect these companies and their stock prices which I will explain later.

Indian Banking Sector
Banks make money by lending money to consumers and earning interest payments (Interest rate * Loan) on them. More are the interest payments from the consumers higher is banks’ revenues. In order to increase the interest payments banks could either increase interest rates or loan amount.

Interest rates to some extent are determined by RBI. Higher interest rates deter consumers to borrow from banks. In the current high inflationary environment, both retail and corporate consumers are shying away from borrowing money from banks. This has seriously hurt not only banks’ profitability but also the overall economy because both consumption and investments are down. Added to this, the ongoing financial credit crisis has made banks little hesitant in lending to other banks as well as consumers. Thus their profitability is down on account of lower revenues and rising costs.

Additionally, Banks can not lend as much as it wants. RBI ensures that all banks maintain Cash Reserve Ratio (CRR) in order to maintain stability and security in the financial market. To fight inflation, RBI has increased CRR over the last six months period which led to lower liquidity in the market. As banks have less money to lend their revenues were down accordingly.

However, with inflation coming down RBI has shifted its focus from controlling inflation to boost growth. We may see better our banks in good health in the coming months. So anyone who is interested in buying banking stocks and holding it for along term might find their valuation attractive.

Indian IT Services Sector
Indian IT services companies such as Infosys and Wipro get over 50% of their revenues from the US. Moreover, over 30% of their revenues from the US come from BFSI (Banking, Financial Services and Insurance) segment. The BFSI segment has been worst affected by this financial meltdown. Apart from that the overall economy has been seriously affected and most of the sectors have seen negative growth rates in the US. Retail firms in the US is facing huge challenges as Americans have started saving and cutting down their consumption. Hence, we could be rest assured that the revenues would be seriously affected for the IT firms. We have already seen Wipro missing the expectation of the street. Many companies have already lowered the earning expectations for the next quarters. Hiring is down by over 50% and we may see layoff by most of these IT firms especially small and mid size players. Attrition rate has improved dramatically and is as low as 8%.

However, there is some hope for the industry. With the impending recession in the US and EU, more companies would be forced to outsource their IT related work to cut down costs. However, this may take six months to one year period to help IT firms.

Indian Real Estate Sector
Indian real estate sector was darling of foreign investors till last year. Did you ever hear about mega real estate deals that happened in Mumbai in 2008? If not here they are: First: London-based banking major Barclays Bank created history in May when it took space at Cee Jay House, a landmark office complex in Worli, for Rs. 725 a square foot (sq ft) per month. Second: Yesteryear movie star Vinod Khanna and his wife set a realty record in Mumbai by buying an apartment in Malabar Hills for Rs. 30 crore after paying a mindboggling Rs. 1, 20,000 per square foot. But those days are over now. The sub-prime crisis has taken its heavy toll on the sector. Mumbai prices after seeing Manhattan levels are back to its root.

Real estate is a capital intensive industry. Firms need to buy land, which is extremely expensive these days, raw materials such as cement and steel, and hire manpower for the construction activities. All of these require huge amount of money. Developers generally raise capital either by borrowing or issuing stocks. RBI has made extremely difficult for the firms to raise debt in domestic market or through external commercial borrowing (ECB). Hence, the best way for them is to issue stocks and raise capital. Unfortunately, the global financial crisis has taken a heavy toll on the Indian stock market. In less than a year Sensex has gone down from 21,000 to 10,000 levels. Most of the real estate stocks are down by over 70% w.r.t to their 52-weeks high. This is because of higher interest rates, global slowdown and heavy selling by financial institutions which have forced firms to cut down their expansion plans. They are stuck with their existing projects while investors have pulled out. Lehman had around $1.3Billion of investments in Indian real estate market. Several developers such as Unitech had planned to raise money through Special Purpose Vehicle (SPV) to fund their projects. Now, after the bust of Lehman, firms may seek PEs help to raise capital.

However, the consumers have great opportunities even in this bear market and higher interest rate environment. With the decrease in demand for both commercial and residential properties, prices/rentals have come down. We have already seen a correction in the range of 5-10% across the properties and believe prices may go down further by another 10-15% in the next 3 to 4 months. Also, the prices in the secondary market have fallen more compared to that in the primary market. We believe inflation might cool off by June 2009 which might push the demand for residential properties. Though the long term outlook looks good, the short-term outlook is extremely difficult for the industry. So if you plan to buy a house wait for few more months but definitely before inflation falls to single digit and banks gradually start rolling off hike in rates.

Indian Automobile Sector
Automobile sector has seen huge boom over the last one decade. Lower interest rates, flexible loan terms and booming economies helped it immensely. However, the current high inflationary and high rates environments have led to a slow down in the industry. This is also an interest rate sensitive industry because most of the car or heavy vehicle sales are done on borrowing i.e. loans. Hence, if interest rates are high consumers shy away from auto loans or existing vehicles or instead use public transportation, which is good across India. Moreover, during the last year prices of raw materials such as Steel shot through the roof forcing auto manufactures to hike the prices. Higher fuel prices haven’t helped it either. High diesel prices hurt the economics of fleet operators which are major consumers of heavy vehicles.

Tata Motors has already laid off over 1000 contract employees in Jamshedpur due to slump in the demand. Sales of Indica were down by 27% in July 2008 while those of Eicher were down by 48% in the same period. Overall, the domestic sales grew by a modest 8% this year compared to the over 25% growth in the export of small cars. These are not encouraging figures for the industry.

Indian Infrastructure Sector
It includes airports, highways, ports, telecommunication and utilities. This is the most capital intensive sector in any economy. Hence, firms are heavily dependent on banks borrowings to construct new airports, ports or other infrastructure related facilities. In the current scenario of high interest rates and lower lending by global banks, this sector has taken a heavy biting. Most of the ongoing projects are facing problems such as lower revenues or making interest payments to lenders. Firms are finding it difficult to raise billions of dollars from the global market to fund new projects. No doubt their stocks are currently out of demand and in deep red.

I am not too optimistic on these stocks. It may take at least six months for things to cool off in the global market and lending to ease. Till then either stay away from these stocks or hold on in order to reduce your losses.

We may see a slower growth in the economy i.e. our GDP growth rate would come down to 7% from 9.5% last year.  The financial crisis may not be restricted only to the above sectors but may trickle down to various other sectors. There is a famous song by Billy Ocean “When the going get tough, the tough gets going.” Thus there would be lower demand, extra supply and lower consumption compared to the last few years of super growth. Unemployment will increase in both organized and unorganized sectors. I don’t know what will come up next. But whatever comes our way, we need to be prepared for that!

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