Sunday, December 04, 2016

Can Demonetization diminish speculation pressure on real estate prices in India?

A perfectly rational way of looking at demonetization is to compare it with an interest rate hike in a credit heavy economy.

In 2004 - the US Federal Reserve began to increase the interest rate and the US  market responded positively for about three years. Around 2007 however the market began to fall and in 2008 - the real estate sector collapsed triggering the Great Recession. The effect of the Federal Reserve hike of 2004 was to deflate speculative pressures and bad debt pooling in the real estate sector. Given the exposure of the US government (through Freddie and Fannie Mae) to this sector there was significant direct damage to the USG as well.

In India - a good fraction of every real-estate transaction is "black". The percentage varies between 30-50% depending on the transaction and size.  Most of this "black" portion is serviced using cash. The "black" cash is actually laundered after the transaction in the form of "white" transactions that are completely fake and dated to look like they took place at some point of time in the past.

In this fashion a greater portion of the "middle class" families in India maintain a loosely defined family corpus or fund. The family fund is neither "white" nor "black" - it is a "gray" entity  - fluid and fungible, and also often legally poorly defined. It can be used to pay for a nephew's education or medical treatment. It may even be in gold or silver. It can even take the form of a good or service - such as free room and board.

I sometimes think that the prevalence of such corpora or funds is what keeps the family as an institution going in India. I also suspect that absence of such corpora or funds is what permits US society to be so different from the Indian society.

By demonetizing certain currencies, one essentially forces a fraction of these corpora to become worthless. As these funds are "gray" entities, only the fraction that is not captured in fake "white" transactions is likely to be affected adversely. That fraction can be quite small if the fund is managed intelligently. As long as this fraction is small - the "middle class" family can afford to overtly support "Prime Minister Modi's bold initiative to end corruption" while covertly scrambling to get receipts to cover the "black" portion of the fund.

This gets me to why there is such a large amount of speculation in the real estate sector in India. Like most other countries, India has a massive shortfall in housing. The number of people who want houses is much higher than the number of houses for sale and the supply demand curve is heavily in favor of the seller. This keeps the price high. This trend is not likely to change in the near future, the population will outstrip housing volumes for the foreseeable future. This perception drives up the house prices. Given the lack of tools to efficiently compute how the prices will really trend - the price of a house is completely driven by speculation.

With such a steady trend in housing prices, most people in India and abroad feel safe using Indian real-estate as place to locate the family corpora or funds (way better than investing in Dubai or America or Britain - where you have to be super rich and friends with the top politicians).  The ease with which any transaction in India can be anonymized ensures that investors from all parts of the world are drawn to the Indian real estate market.

When you take those things together - you realize that the real estate bubble in India is driven by two forces. A steady flow of capital from within and outside the country that is blowing up the balloon and an extremely slow rate of infrastructure growth that is preventing a major shift in the supply-demand curve for housing. The former is driven more by patterns of international trade (and basically by the returns on the US 10 year treasury bond) and the latter is driven by India's internal (socially driven) limitations on growth.

As discussed earlier - government regulation (like demonetization or the Electronic Property Pass Book - EPPB) can only shift the desirability of Indian real-estate by small amounts. The biggest impact may be on the "gray" corpora and funds of "middle class" Indian families and if the EPPB is introduced, then perhaps there will be reduced anonymization of the transactions but it is not going to make a dramatic impact on the real-estate bubble.

As long as that bubble exists in India, it will pose a similar threat to the Indian economy as the US real estate bubble did a decade ago.


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