What if the bubble doesn’t burst

Formation of asset bubble invariably harms the economy whether it bursts or not. We have already seen the unprecedented inflation. The food price has gone up many fold over past 6/7 years. Surprisingly, somehow, most analysts fail to relate food price with property or rather find the connection ridiculous. However, an analyst with basic mathematics, common economic sense and an out-of-the-AC-cabin field observation can set a simple equation between property price and food price.

Up to 100 km around Mumbai, it is much more profitable for farmers to sell mango orchards as second home plots rather than producing Alphonso mango. So one can easily calculate, given the yield of Alphonso, what the price of the mango should be to forgo selling the orchard to the urban rich.

In an economy all asset classes are interrelated directly or indirectly and thus maintain a balanced equation. An asset price is termed bubble, when it grows much beyond the equation. So if the particular asset price remains high and sustains at that level without correction, the other asset price tends to move up to maintain the balance.

If the property price doesn’t come down, the house rent should move up to balance the equation between rental income and property price. So the house rent should move up to an unaffordable like level to match the equation with already unaffordable property price. Reportedly the house rent in places like Navi Mumbai has started moving up at a very high rate. And if house rent goes up to unaffordable level, logically the price of other stuff will also go up to similar level. Thus an unthinkable level of inflation is in offing, if the property price doesn’t correct soon.

(Recently we valued the property of a Mumbai based company with a huge land parcel, where the company intends to build office space for lease purpose. The land value, according to current property price, is more than two times the present value of the total rental income.)

Why a bubble cannot be checked

In an open economy it is difficult to prevent an asset bubble formation. The basic problem is that people fails to recognise a bubble till it becomes too big. A government intervention in the so called price discovery system is against the principle of free market economy. Chinese government, of late, has taken steps to discourage property buying in order to deflate their property bubble.

Banks can definitely play a vital role in preventing an asset bubble in housing property market. Around 80% or more of a housing property is financed by bank. But apparently banks don’t have a property valuation methodology. Instead of valuing the property, the collateral, banks consider the market price justified and give importance only to the repaying capacity of the borrower. That is very unusual in the investment world. Thus the banking system becomes subject to the danger of a housing bubble burst. In a fallen market a property may be less valuable than the outstanding debt and a professional investor will prefer to default resulting losses to the bank.