Of RBI, Real Estate, SME Rate Cuts, and case of Missing economic Recovery

As per the latest report by RBI, housing inflation is moderating, or to speak in normal English, housing prices grew by 5.2% in Jan to March period of 2016 while they grew by 9.8% in October to Dec 2015 quarter. Growth of 5% to 9% in a sector, which is considered to be dead and needs a push by Govt in terms of lower home loan interest rates!!! A similar increase in food prices would have turned media crazy by now with big headlines and debates on prime time. However, an inflation of 9% in a dead sector didn’t even merit a front-page mention; leave alone a headline. Such is the curious case of housing as a sector, which has remained a mystery in India despite all kinds of experts and their analysis.

Housing prices, which started to rise in 2002 onwards, have defied every logic and have seen only rise and rise without any sign of cooling off or price correction. The experts have been talking of housing bubble since 2006, but were forced to swallow their pride. Even the massive financial crisis of 2008-09 saw no pricing correction in Indian real estate, except some minor slow-down where rather than prices going down, deals stopped happening – an attribute which demonstrated the massive staying power of investors / builders. Majority of analysts attribute this phenomenon to the presence of black money, which allows builders to remain oblivious to the pressure of liquidity or market forces. Nothing can be farther from the truth.

There is a naive belief among the experts that it is black money, which is providing the liquidity, and hence, not allowing prices to correct. Real estate prices have been high not due to black money (it is a very small component) but due to liberal housing loans, largess of PSU banks, wrong RBI policies, and the strange income tax laws in the country. These three arms of government are the reason as to why real estate remains almost out of reach for majority of low-income and middle-income families. Yes – RBI has quite a role in diverting money to real estate from all other important sectors of the economy.  

Hence, in a nutshell, it is the great socialist, pro-poor, middle-class-centric Indian Government, which has ensured that there is no price correction in real estate, and prices are maintained high by providing right stimulus in the garb of helping average middle class and poor.

So let us examine the case of all major players behind super abnormal high prices of housing in India.

In India, the housing boom was triggered by affordable home-loans, which hovered around 7%-8% once upon a time and encouraged the young population to buy houses and get into life-long debts. People always demand more rebates or lower interest rates without realizing that the rise in housing prices has been a function of lower interest rates, as there is very little relationship between “cost of building a house” and “sales price of house”.

As it sounds counter-intuitive, let us take the price movement of a housing project.

A builder launches a project at the launch price of INR 3000 per sq ft and takes around 3 years to complete it. However, by the time the house is ready to move in, the price moves up to INR 7000-8000 sq ft. Hence, one can easily see that there is hardly any relationship between price of housing vs cost of housing (remember that the builder project was viable with 30% IRR even at INR 3000 per sq ft). So one wonders as to what changed in three years that made the price go double or triple?

The answer is not the cost inflation but “risk premium”. Given the fact that almost 95% of housing projects are delayed beyond 2 years and some never finish, there is a huge risk premium for a ready-to-move-in-house compared to a newly announced project as there is no liability / pressure on builder to deliver the project on time in latter case. Though present Govt has passed a real estate regulatory law, but given the state of judiciary in India, one wonders as to what change this bill will bring in reality.

This risk premium brings huge returns to investors and other players, and hence, creates huge incentive for prices to remain high. In the 2008 financial crisis, while the whole world was collapsing under massive liquidity pressure, there was no movement or pressure on Indian builders to cut the price, as PSU banks were happily restructuring the loans to accommodate India’s real estate. Now before you jump to conclusion and blame PSU banks-politician-bureaucrat nexus, its high time we look at RBI policies, which have encouraged or rather nudged banks to disburse loans to builders in a most liberal way.

One must understand that the price of an asset is not just the function of supply and demand but also a function of liquidity, and unfortunately, liquidity in real estate has been maintained through RBI policy of lower risk weightage.

As per RBI policy, housing loan is given a risk weightage of 35% while SME loan gets 100% risk weightage. On top of it, for SME loan, one has to provide collateral or fixed deposits to avail a loan at 12%. While in case of housing loan, no such collateral is needed (it is another matter that a significant amount of those flats are never build). Hence, by keeping favourable risk weightage, liberal guarantee / mortgage policy, RBI has created a scenario of crowding out the capital where banks focus on disbursing loans to housing sector rather than SME sector, which is the real driver of the economy.

Experts argue that real estate is far less risky than SME; however, they forget the fact that more than 1 lakh houses are delayed beyond 2 years (Jaypee Group loan on account of its housing is close to INR 90,000 Crore). If one takes retail housing loan on these delayed and abandoned projects, the amount of loan being carried by all individual house-owners will easily cross INR 50,000 Crore. In a way, one can say that close to INR 50,000 Crore of consumption at household level is forever locked in unproductive assets and is creating massive difficulty for those families.

However, risk weightage is not the only tool driving liquidity to real estate sector, there are other very sub-prime kind of lending scenarios to which RBI turns a blind eye.

RBI, which closely monitors functioning of banks, has curiously ignored banks’ participation into a highly risky financial product called “subvention scheme” offered by real estate players. In subvention schemes, a builder asks the home-buyer to take home loan in his name while proposing to pay EMI on behalf of home buyer till possession is done. This scheme is akin to a derivative scheme where the risk is held by bank / borrower, while money is taken by builder without any risk. There have been many cases where builders disappeared after promising all kinds of guarantees; thus putting capital at risk for banks and borrowers.

And if the nexus of RBI and banks was not enough to keep real estate prices high, income tax laws are also structured to give more benefits to investors / speculators than to first time buyers. So if you are a first time buyer of house, rebate in income tax is capped at INR 1.5 Lakh for the interest paid on housing loan, but is unlimited if you are buying house for investments. So If your EMI is 30,000 a month (yearly 3.6 lakh where interest amount is 3 lakh), you will get benefit of 1.5 lakh only if you are a first time house buyer (self-use) but will get full 3 lakh benefit if you are an investor and there is no limit. So practically, as a high-net-worth individual, you can use this provision to minimize your tax outgo by investing in real estate and keeping the liquidity high. Quite innovative techniques by a socialist, poor-focused Govt to keep liquidity and prices of real estate high!

The proponents of real estate tout the benefits accrued to nation on account of contribution to GDP, job generation, and stress upon fulfilling the basic need of citizens, which is housing. Citing this need, every year demands are made to reduce interest rates and give more benefits to loans at a certain rate. Interestingly, they never demand reduction of liquidity, lowering risk premium, or reducing costs of houses. Despite news of so many houses remaining unsold, we always hear a friendly request to the builders from the Finance Minister or RBI Governor of that time to reduce house prices.

Dr Rajan, who is known to be quite aware of the risks created by housing (he predicted the 2008 crisis), remained oblivious to the risks created by wrong policies of RBI / Banks, as far as real estate is concerned. Interestingly, despite deep insight into the workings of banking system, the RBI never restrained banks from providing additional liquidity to real estate, or stopped fancy derivative schemes, like interest subvention, etc. This continued liquidity given to housing sector in the form of lower interest rates (through lower risk weightage and subvention schemes) has created massive build-up of risk in Indian banking system in the form of housing. Strangely, Dr Rajan didn’t take any action in terms of normalizing exposure to housing sector.

Such anomalies – i.e., low risk weightage, low interest costs, convoluted income tax laws – have created serious danger to Indian economy, as it is at one end creating loan bubble in the books of the banks, while on other hand, is reducing consumption at ground level, since majority of free cash flow at a household level is going towards servicing loan / rent.

Hence, the mere thought that Indian economy will suddenly revive due to implementation of 7th Pay Commission, or some fancy acronym, like Make in India, without any serious policy shift is at best a mirage and at worst a hallucination.

Here pay commissions are an interesting twist. In 2006, Indian Govt, without any inkling of upcoming 2008 financial crisis, set up 6th Pay Commission to review and revise the salary of Govt employees. The 6th Pay Commission resulted in massive jump in salaries as well as ended up releasing a one-time payment of close to $ 6 Billion in the hands of Govt employees. This accidental stimulus almost worked as fiscal stimulation and insulated India from global financial crisis. Having discovered “pay commissions” as panacea for all ills, the mandarins at South Block hope to kick-start Indian economy once again by using 7th Pay Commission; however, probability of its success are remote. Firstly, the jump in salaries is not as significant as they were last time (27% jump in salary compared to 300% jump last time), so no massive boost in consumption is expected. Secondly, additional outlay in salaries will strain Govt finance and will not only limit fiscal intervention but will also push fiscal deficit. So if 6th Pay Commission saved Indian economy, 7th Pay Commission has the capacity to sink it.

The only way India can resurrect its economy is by working to increase consumption at household level and propel SME sector by bringing their cost of debt to 10% or below without decreasing the interest rate for housing or deposits.

In fact, the pro-Rajan lobby is quite right in their view that a sharp cut of 300 basis point will create double whammy for Indian middle class, as it will lead to lowering of deposit rates (the de-facto saving instrument of Indian public) while create asset bubble (real estate prices will again rise due to lowering of EMIs and availability of liquidity), and push inflation short-term (higher money supply).

The paradoxical task of not reducing deposit rates and bringing down SME debt cost can only be achieved by re-allocation of capital. RBI needs to increase risk weightage on housing to at least 100% and also increase the cost of housing loan by at least 300 basis point for 2nd / 3rd house. Further, Govt can eliminate the impact of this increase in EMI by doing suitable amendments in income tax where 100% income tax benefit shall be provided for 1st house per individual. This step will bring benefits to end users while crowd out short-term investors and bring much-needed correction to the housing sector.

On the other hand, policy makers need to re-adjust risk ratio for SME and bring the lending to SME at par with priority sector. This will channelize the fund flows to SME sector and will also bring down cost of debt.

Hence, rather than focusing on food inflation, Finance Minister needs to focus on reducing cost of housing, education and healthcare, and also aim to create capacities, and eliminate anomalies. If such counter-intuitive measures are not taken, capacity building and consumption in economy will not kick in, and this Decade will be more of a Lost Decade than India Decade. 


Excerpts of the above article have also been published by Swarajya Magazine with the title: How Wrong RBI Policies And Irrational Income Tax Laws Keep Housing Prices Abnormally High

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Shailesh Vickram Singh

Shailesh Vickram Singh is an entrepreneur / venture capitalist with more than 20 years of exp.