Asset price bubbles and Systemic Risks: Considering evidence in India

By Chirag Mehta

For quite some time newspapers have been running stories of dwindling sales of real estate properties -hardly surprising given the state of the economy, but for the fact that, prices are still increasing, defying basic economic logic. This article considers evidence of a possible asset price bubble and its likely implications.

If there is ever a need for an example for the adage – innovation sprouts in the face of adversity, then one needn’t look further than India’s real estate sector. Faced with the burden of slowing demand, mounting inventories and a stubbornly high interest rate, developers have come up with an ‘innovative’ scheme where apparently all parties gain.

The details of the scheme, popularly known as ‘80:20’ are all over the internet and the purpose of the article isn’t to go into its nitty-gritty. To explain it succinctly, the scheme allows investors to purchase property on a 20% down payment with interest payments on the loan for the balance 80%, only after taking possession. The developers’ benefit from the lump-sum receipt of the loan by the bank at a lower interest rate since the loans remained in the name of the investor. Moreover these loans are generally disbursed without any connection to the stage of completion of the project.

Even at casual glance, the additional risks and dangers these kinds of products introduce, is quite obvious. Not surprisingly, the RBI issued a subtle and carefully worded directive asking banks to “ensure that the borrowers/customers are made fully aware of the risks and liabilities under such products.”, in effect clamping down on such, what ought to be called, nefarious schemes. But the more pertinent question is, exactly how troubled are developers, that they need to turn to such schemes, and subsequently what is the potential impact, a sector-wide downturn may have.

Is India atop a housing price bubble?

The closest any state official has come to answering this question explicitly, is (ex) RBI governor Subbarao – No. In hindsight however it seems obvious that no one would suggest anything but. In any case, given the frequency with which stories of a property market crash are appearing, it certainly warrants a closer look.

In India, housing prices are currently measured by two organizations, namely the RBI and the National Housing Bank, its subsidiary. According to the RBI’s composite Housing Price Index, house prices have nearly doubled since 2008-2009. Data shows that real estate has consistently outperformed other asset classes, which just furthers people’s expectation that they are immune to economic forces.

(Figure 1)

However recent trends show that prices are not increasing at the same pace, and in many cases are even declining. That is certainly what the National Housing Bank’s recent report suggests.

Coupled with the fact that sales are decreasing across segments, from high-end to affordable housing, it certainly seems likely that something is amiss. Add to this the whopping increasing in accumulated inventory, and the picture almost becomes alarming. Recent research on inventory pile up shows that inventories have almost doubled in the last 3 years. In the NCR, inventory reached 31 months at the end of March 2013 as compared to 15 months in March 2010, while in Mumbai it has touched 40 months from that of 17 months during the same period. The pattern is much the same for most other large cities. That doesn’t leave too much room to doubt whether prices are artificially high. That the developers lobby group, (CREDAI), is continually pushing for relaxation of credit norms only corroborates this assertion.

 

Importance of the Housing sector and Implications of a downturn

Housing wealth comprises a significant component of household networth; hence movement in house prices may affect consumption. Some research certainly points towards a positive correlation between the two (Campbell and Cocco, 2008) though there isn’t strong consensus over the issue.

However, the more important point is the relationship between housing and the banking sector, since most houses are purchased by availing of finance. If the US Financial Crisis of 2008 has made anything clear, it is the fact that financial systems are the nerve centers of economies and any spillover to it will only exacerbate the problem and may even have a contagion effect. It is in this context that the situation of the asset price bubble in India becomes worrisome.

 

(Figure 2)

RBI data on sector wise credit disbursement shows that although over the years credit to the housing sector has declined as a proportion to total disbursements, it is picking up again off-late; and while justification for this could be ‘loans for affordable housing’, data suggest just the opposite – the share of credit to Priority Housing (low-cost affordable housing) is on the decline.

This is hardly surprising given the string of real estate scams that have emerged in recent years. The simplest route employed by schemers for extraordinary profits is to purchase prime land, at subsidized rates on the pretense of ‘affordable housing’, and then construct the most lavish ‘palaces’ for the open market – as the Supreme Court observed in one case. Fraudulence aside, what needs immediate attention is the increasing rate of credit disbursal.

Consider these points – bank NPAs (the most critical measure of a banks health) are continually increasing (at least for PSBs which account for the largest share of bank assets). This given, even a modest correction could sharply affect those critical figures leading to widespread panic. If the panic persists, real estate prices could free fall – this is because unlike financial assets which can be liquidated virtually overnight, real assets don’t have such a ready market and in times of panics, investors may have to conduct a fire sale – the critical link between a banking crisis and the real estate sector being that a majority of NPAs are arising out of this very sector.

Likelihood of such a scenario

While a large portion of the impact depends on the magnitude and rate of price correction, it isn’t very likely that the government will let a panic situation spread – at least not one which it has the tools to control. The RBI would give its assurance that banks are sufficiently capitalized to absorb such shocks, and in compliance with the Basel Norms. Additionally, the government could always step in to marginally recapitalize the banks, to give a positive signal, which should be enough to calm any concerns.

Despite such a contingency plan, if the bubble does burst, some fallout will most certainly occur.

1. Unemployment will rise, since construction is a labour intensive industry.
2. Fiscal deficit target may be missed – The situation will entail costs which will increase the burden on the exchequer. Even if recapitalization of banks is ruled out, some programs may have to be undertaken to control the sudden increase in unemployment.
3. Growth will be impacted – institutions will most likely lower their outlook on India, which will have its respective ripple effect.

Concluding remarks

Evidence certainly points towards artificially high asset prices, but that in itself doesn’t mean that it is likely to collapse soon. The downturn depends largely on several factors, including how long the industry can keep prices propped up and the rate at which prices decline. Also one should consider the return trends from other asset classes as well as market perception to the recent report by the NHB shows that prices are indeed falling in the large cities.

Another potential factor which could stabilize the sector is investment from NRIs. With the depreciation of the INR, repatriating income has become more popular, and real estate is still viewed as the perfect store of wealth by the community, although even they are being cautious with the recent slowdown.

However in the event that, developers reach desperation and start giving large discounts to unload some of their inventory, it may spark off a larger panic where everyone would rush to the exit to salvage their investments. The price slump would directly affect banks, and lead to a larger panic, with at least some economic costs even if the situation is immediately brought under control.