A major reason for the price of crude oil falling has been the accumulation of oil inventories all over the world. Inventories in any commodity are a result of supply being more than demand. The trouble is that in case of oil there is only a limited amount of storage space available and this can lead to rapid decline in price, once the inventories start to build.
As the analysts at Bank of America-Merrill Lynch point out in a research note dated January 16 and titled Oil price undershoot; Compelling value emerging: “Inventories all over the world are building at a very fast rate. In fact, we have moved up our storage numbers and now expect OECD (Organisation for Economic Co-operation and Development) inventory levels to reach 2,830 million barrels in 2Q15, 180 million barrels above last year.”
Even in the United States, there has been huge build up in oil inventories. Numbers released by the Energy Information Administration(EIA) of the United States suggest that on January 16, 2015, the oil inventories in the country stood at 397.853 million barrels. Thus the oil inventories “are at the highest level for this time of the year in at least the last 80 years,” the EIA said in the release.
Hence, this huge build up in oil inventories has led to the oil price crashing.
This led to one of the editors at Firstpost to tweet that despite huge inventories in the real estate sector in India, why are prices not falling, like they have in case of oil. In this piece published on Firstpost I discuss why real estate in India remains unaffordable. One of the tables in the piece shows the huge amount of home inventory in various cities. There are huge amounts of unsold flats which have been built but have not been sold.
A simple straight forward answer too high inventory not leading to falling prices is that there is too much black money in the country. And that black money keeps finding its way into real estate, keeping prices high. An article in The Caravan magazine a few years back captured this point beautifully when it said: “There isn’t a bubble of real homes…If all these apartments were actually built, and built fairly to schedule, I guarantee you that they would find real buyers. The demand is out there. But there is a huge bubble in imaginary homes.”
The reason for this is that the ill-gotten wealth of politicians has been invested in real estate through the “benami” route over the years. In fact, the government or rather governments (the central government as well as state governments all over India) can do a few basic things to try and reverse the situation.
One straight forward way is to start selling land that they own and push down land prices. The consultancy KPMG in a report titled Affordable Housing – A key growth driver in the real estate sector points out: “The government holds substantial amount of urban land under ownership of port trusts, the Railways, the Ministry of Defence, land acquired under the Urban Land (Ceiling and Regulation) Act, the Airports Authority of India and other government departments.”
But this hasn’t happened despite being a very obvious solution primarily because the ill-gotten wealth of politicians is in real estate and any fall in land prices will push down home prices and in the process lead to the value of the “real” wealth of the politicians falling as well.
As Bombay First points out in a report titled My Bombay My Dream: “Government and the land mafia in fact do not want more land on the market: after all, you make more money out of the spiralling prices resulting from scarcities than you could out of the hard work that goes into more construction.”
Further, banks are also playing an important role in ensuring that real estate prices continue to remain high. As India Ratings and Research points out in a recent report FY16 Outlook: Real Estate Sector: “Bank credit to the sector grew by double digits yoy in 2014. This, when coupled with declining sales, indicates bank funding is being used to build up inventory, which may further deteriorate the credit profile of the sector.”
The report further goes on to point out that: “Any fall in property prices will require steps for reduction of land costs, shortening of the approval process and removal of red tape and also pressure from lenders on such companies to liquidate inventory to reduce debt.”
What this means in simple English is that banks need to pressurize real estate companies to repay their loans instead of giving them fresh loans to repay their older loans.
But that is just one part of the story. To understand the other part of the story we need to understand an economic theory called “a market for lemons” put forward by Noble prize winning economist George Akerlof (these days more famous as Mr Janet Yellen). Akerlof wrote a research paper titled The Market for “Lemons”: Quality Uncertainty and the Market Mechanism in 1970.
In this rather unusual paper Akerlof discussed the second hand car market in the United States. He pointed out that there are essentially four types of cars. “There are new cars and used cars. There are good cars and bad cars [which in the United States are known as “lemons”]. A new car may be a good car or a lemon, and of course the same is true of used cars.”
An owner of a car has a good idea about whether his car is a good car or a lemon. This leads to what economists call an “information asymmetry”. As Akerlof put it in his research paper: “After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine…An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers.”
This leads to a problem where the buyer of the car has no idea as to how good or bad the car is. Hence, as Akerlof put it: “The bad cars sell at the same price as good cars since it is impossible for a buyer to tell the difference between a good and a bad car; only the seller knows.”
And given that the buyer has no way to differentiate between a good car or a lemon it is ultimately reflected in the price of the car. Tim Harford explains this phenomenon in his book The Undercover Economist. As he writes: “Anyone who has ever tried to buy a second-hand car will appreciate that Akerlof was on to something. The market doesn’t work nearly as well as it should; second-hand cards tend to be cheap and of poor quality. Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car is really a peach, they cannot get that price and prefer to keep the car for themselves.”
Information asymmetry essentially ensures that the market does not work well. As Nate Silver writes in The Signal and the Noise –The Art and the Science of Prediction: “In a market plagued by asymmetries of information, the quality of goods will decrease and the market will be dominated by crooked sellers and gullible and desperate buyers.”
If this sentence strikes a chord then you have perhaps been trying to buy a home somewhere in India. The Indian real estate market is totally rigged one way. The information asymmetry totally works in favour of real estate companies, builders and brokers who are a part of this industry.
Something as straightforward as what is the going price of a flat or house in any given area is very difficult to figure out. The only source of information on this are the brokers or the builders themselves. And the world that they live in, real estate prices only go one way and that is up. This helps sustain the myth that real estate prices only go up. Given that there are no other sources of information, people end up believing everything that their broker tells them.
Also, what the buyer does not know is the volume of transactions that have happened at the price being offered by the brokers (This is visible in the miles and miles of built and unsold homes all over the country). So, there is no way of verifying anything. The buyers have no way of figuring out whether deals are actually happening or not and hence, need to either believe the broker or play mind games with him.
As Jeff Madrick writes in Seven Bad Ideas—How Mainstream Economists Have Damaged America and the World: “Almost all homebuyers…enter into such transactions only two or three times in their lives. How can they possibly be knowledgeable and informed?”
Given these reasons, even with a huge inventory, real estate prices in India are not falling. And this has led to a situation where sales have fallen dramatically. “Sales of fresh residential units (in sq.ft.) by listed real estate companies continued to decline during 2014, falling 25.6% yoy for the 12 months ended September 2014,” the India Ratings and Research report points out. In fact, this is also reflected in the fall in home loan disburals between April and September 2014.
The question is will home prices fall during the next financial year (i.e. April 2015 to March 2016)? “While economic growth is likely to improve in FY16, property prices might not correct. This could lead to endcustomers postponing purchase decisions,” feel the India Ratings and Research analysts.
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)
The article originally appeared on www.firstpost.com on Jan 30, 2015