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Sooner or later, no column worth its name can resist the temptation to dip into east Asia's nightmares to come up with a piece of what it imagines is a piece of economic folk wisdom. "Eye on Economy" cannot either. My favourite story here is the role of the property sector in bringing about the divorce between investors and borrowers in east Asia. The tale, devoid of all jargon, is really about building castles in the air. As the region's economies started doing well, the demand for commercial property, naturally, started rising. Canny businessmen saw a no-loss situation, because as long as the region did well, the demand for commercial and office space would increase fast. Naturally, nobody saw any reason to doubt that the region would continue do well.
Private builders were allowed to borrow and build on the basis of collateral of built up property valued at market rates, forgetting that this value was entirely dependant on the confidence in the entire market. If this confidence waned, the entire pack ofcards would come tumbling down.
And this is exactly what did happen. The region's currencies were more or less pegged to the value of the dollar. As the dollar rose, east Asian exports became more expensive and started declining. Since this region had always been massively dependent on exports for growth, the fall in demand for their exports hit their fortunes very hard. Predictably, the demand and therefore prices for office space also took a critical hit.
At the same time, these property prices had inflated the book worth of a lot of people. Naturally, as they felt themselves getting wealthier, they had spent more. The important point here is that these foreign monies which went into financing this property bubble, was ultimately used to finance consumption and not investment. This meant that the excess of their spending over saving, or the current account deficit, would ultimately prove to be unsustainable in the long run. Certainly, foreign investors began to recognise this at some point early in1997. Thailand was the first to go, and once the panic set in, there was no stopping it, as property and currency prices tumbled in an indecent haste to the bottom. Banks in the region, which had lent heavily on the basis of property collateral, found themselves with a pile of rubble on their books, worth considerably less than what they had lent out.
This brings us to one of the central problems with property markets everywhere. They are highly cyclical in nature, with accentuated boom and bust cycles corresponding to general movements in business cycle. This tends to increase the risks and rewards associated with investing in commercial property rather than residential property.
Take for example, property markets in India. Any broker who values his two bits will tell you investments are best made in commercial property in one of India's big cities rather than wait for demand to affect property prices elsewhere. This is due to a number of reasons. The demand supply gap, or rather the effective demandsupply gap is at its most acute in our bigger cities like Mumbai, which makes property in these areas so much a smarter risk to take.
This makes an investment in property rather like a call option on a share, where the investor has the option of exercising his option at a specific price. For sure there is a chance the investor may lose his shirt on a downswing. But the potential returns in the commercial property market are so large that most bets are worth the risk. In a boom, commercial property prices will rise much faster than residential property prices. In other words, the strike price at which the investor can exercise his option is much higher in commercial property in a metropolis. And this leads to another fact that tends to keep prices from coming down. Since the potential returns are so high, landlords would rather hang on to their property and sell it or lease it when prices are appropriately high rather than do so at lower prices when the good times turn bad. This means that even if vacancyrates rise, sale and lease prices tend to remain on the higher side. Our outrageous laws on land holdings and rents have made this situation worse in the past by artificially limiting the supply of space in cities. Rents and therefore property prices therefore tend to remain high, which makes investing in city space so much more sensible.
It is in this context that you have to look at attempts to bring in foreign investments into the housing sector. Certainly, we could use the money. At the last count, the gap between the demand for and supply of housing was estimated at around 33 million units. But if foreign money were rational, it would decide investments in commercial property make more sense than in residential property. Unless curbs are placed on where foreign investments in real estate are to go, the major chunk could end up inflating city land prices even more.
Even if much of these investments were in the form of FDI rather than short-term debt, their concentration in big cities would drive upprices to such an extent private builders would start building unnecessary city space all over again. This might have two effects. As money flows into the commercial property sector, prices would shoot through the roof, which might lead to the same kind of wealth effect and consumption boom as in Asia. This rise in consumption might result in an unsustainable rise in current account deficit. This is because these borrowings are not being used to invest in productive capacity that would generate a rate of return higher than the cost of funds in the long run. On the other hand, when the business cycle enters a downswing, the glut of property holdings might lead to a rash of bad debts.
There is no reason to expect we should be more immune to property bubbles than people in Thailand or Malaysia. In fact, funnily enough, such bubbles could be worse in a basically sound economy like ours. This is because investors would be less worried about the risks, and pour in money faster into the property sector,increasing the risk of such bubbles. So, depending on the way you look at it of course, you might not want to let those fickle foreigners buy you that nice new house. Not unless you are willing to risk the shirt off your back for it.
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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