Recession and real estate in India
The Economic Times, February 2009, Page 14
In an earlier article (ET, Nov 19) I had argued that the current global recession has clearly dominant Keynesian features. The crucial issue is not just the fact that there is a demand contraction but that this has been brought about by a market failure which fuels adverse expectations on the part of both producers and consumers.
These adverse expectations lead to reduced production by producers anticipating lack of demand and increased savings by consumers anticipating lack of jobs. Over time, actions of both producers and consumers further justify their expectations which then become self-fulfilling.
In the absence of government intervention (which fills in the missing demand) it is not clear when and how such expectations get reversed. In the 1930s, it took a whole decade to reverse such expectations and even then only because of government intervention. Today, governments have already started coordinating actions and it is unlikely that this recession would last as long.
However, it is still foolhardy to guess when exactly the current recession would come to an end. We have various guesstimates ranging from end 2009 to middle 2010 but it must be clearly realised that there is no scientific basis for such estimates. After all, how can one estimate when the "feel good" factor returns to reverse adverse expectations?
The crucial role of expectations is also clear from the fact that monetary policy has successfully driven interest rates to near zero levels in most OECD countries and yet there is still no sign of demand recovery.
In India too the RBI has tried valiantly to drive interest rates down. Yet the impact seems limited. Over the period September to December last year the RBI pumped in almost all the liquidity it had sucked out of the system in the preceding 12 months. Yet, the PLRs of banks have barely fallen and the new funds have only found their way into the market for government’s T-Bills. Bank holdings of T-Bills are way above the legal requirements. In other words, banks would rather hold government notes promising about 3% to 3.5% return rather than lend to investors at even reduced rates of 7% to 8%! A strange situation where the government pumps money into the system only to see it finding its way back to them via funding of government debt! Expectations are adverse indeed.
This is particularly important in the real estate sector which is now going through very rough times (likely to get much rougher!). The importance of the real estate sector in India cannot be understated given the strong forward and backward linkages that it generates.
The sector has demand implications for intermediate inputs like steel, cement, etc., while keeping afloat the whole construction industry including transport and other intermediate labour services. Given its importance for the economy it is worthwhile to see how adverse expectations are playing a role in this sector and what are the possible solutions.
It should be noted that the role of expectations is particularly important in sectors where speculative activity is greatest. Speculation is typical of the real estate sector in India. A simple test is to compare the purchase price of a property (commercial or residential) with its rental rate.
Casual empiricism indicates that the rental on a residential 2BHK property in a major metro like Delhi is around Rs 1,20,000 per annum. The purchase price of a similar property was around Rs 50,00,000 last year. However, the return on a fixed deposit of Rs 50,00,000 at around 10% per annum would be almost five times the rental. The difference is the return to speculation.
It is not surprising then that adverse expectations have hit the real estate sector hardest. Why are monetary measures not succeeding? For one, the banking sector has still not reduced interest rates sufficiently. Today, bank rates are still around 10-11% on a long-term housing loan.
This must come down to around 6-7% to attract new borrowers. Second, as the RBI periodically announces measures to reduce interest rates this fuels expectations of further cuts and discourages investment in all fixed assets including real estate.
Third, developers are obviously caught in the speculation trap having mopped up most of their own properties in the past on the assumption of a speculative gain in the future. While they have so far expected the government to bail them out, this is unlikely to happen and one can expect substantial property price reductions in the next one year.
The bottom line? The real estate sector has so far relied mainly on upper income domestic demand and external demand. This is unlikely to revive in the near future. For the mass domestic market the ‘Indian dream’ of owning one’s own home is unlikely to be realised at current prices. Only a combination of much lower home loan rates and a significant drop in prices can energise the real estate market on a sustainable basis. What is clear is that monetary measures alone will not suffice at least in the short run.
The Economic Times, February 2009, Page 14
In an earlier article (ET, Nov 19) I had argued that the current global recession has clearly dominant Keynesian features. The crucial issue is not just the fact that there is a demand contraction but that this has been brought about by a market failure which fuels adverse expectations on the part of both producers and consumers.
These adverse expectations lead to reduced production by producers anticipating lack of demand and increased savings by consumers anticipating lack of jobs. Over time, actions of both producers and consumers further justify their expectations which then become self-fulfilling.
In the absence of government intervention (which fills in the missing demand) it is not clear when and how such expectations get reversed. In the 1930s, it took a whole decade to reverse such expectations and even then only because of government intervention. Today, governments have already started coordinating actions and it is unlikely that this recession would last as long.
However, it is still foolhardy to guess when exactly the current recession would come to an end. We have various guesstimates ranging from end 2009 to middle 2010 but it must be clearly realised that there is no scientific basis for such estimates. After all, how can one estimate when the "feel good" factor returns to reverse adverse expectations?
The crucial role of expectations is also clear from the fact that monetary policy has successfully driven interest rates to near zero levels in most OECD countries and yet there is still no sign of demand recovery.
In India too the RBI has tried valiantly to drive interest rates down. Yet the impact seems limited. Over the period September to December last year the RBI pumped in almost all the liquidity it had sucked out of the system in the preceding 12 months. Yet, the PLRs of banks have barely fallen and the new funds have only found their way into the market for government’s T-Bills. Bank holdings of T-Bills are way above the legal requirements. In other words, banks would rather hold government notes promising about 3% to 3.5% return rather than lend to investors at even reduced rates of 7% to 8%! A strange situation where the government pumps money into the system only to see it finding its way back to them via funding of government debt! Expectations are adverse indeed.
This is particularly important in the real estate sector which is now going through very rough times (likely to get much rougher!). The importance of the real estate sector in India cannot be understated given the strong forward and backward linkages that it generates.
The sector has demand implications for intermediate inputs like steel, cement, etc., while keeping afloat the whole construction industry including transport and other intermediate labour services. Given its importance for the economy it is worthwhile to see how adverse expectations are playing a role in this sector and what are the possible solutions.
It should be noted that the role of expectations is particularly important in sectors where speculative activity is greatest. Speculation is typical of the real estate sector in India. A simple test is to compare the purchase price of a property (commercial or residential) with its rental rate.
Casual empiricism indicates that the rental on a residential 2BHK property in a major metro like Delhi is around Rs 1,20,000 per annum. The purchase price of a similar property was around Rs 50,00,000 last year. However, the return on a fixed deposit of Rs 50,00,000 at around 10% per annum would be almost five times the rental. The difference is the return to speculation.
It is not surprising then that adverse expectations have hit the real estate sector hardest. Why are monetary measures not succeeding? For one, the banking sector has still not reduced interest rates sufficiently. Today, bank rates are still around 10-11% on a long-term housing loan.
This must come down to around 6-7% to attract new borrowers. Second, as the RBI periodically announces measures to reduce interest rates this fuels expectations of further cuts and discourages investment in all fixed assets including real estate.
Third, developers are obviously caught in the speculation trap having mopped up most of their own properties in the past on the assumption of a speculative gain in the future. While they have so far expected the government to bail them out, this is unlikely to happen and one can expect substantial property price reductions in the next one year.
The bottom line? The real estate sector has so far relied mainly on upper income domestic demand and external demand. This is unlikely to revive in the near future. For the mass domestic market the ‘Indian dream’ of owning one’s own home is unlikely to be realised at current prices. Only a combination of much lower home loan rates and a significant drop in prices can energise the real estate market on a sustainable basis. What is clear is that monetary measures alone will not suffice at least in the short run.
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