Are we going to face problems of deflation? Part 1

Since nothing is happening much on real estate front, I decided to take a look at things happening at broad macroeconomic level in India and elsewhere. The very first thing that struck me was falling inflation and fear of defaltion everywhere. Nowadays we keep on reading that global economies such as US and Europe will face severe problems of deflation due to recession. Fed fund rate in the US is between 0.00-0.25% or 25 bp (100 basis point = 1%). Inflation in these countries is close to 0. Even in India inflation is down from 12% last august to 3.5% last week. With the falling interest rates in India will we too face similar situation?

Deflation is a “sustained” fall in the general price level of goods and service below zero percent inflation. It results in an increase in the real value of money — a negative inflation rate. It is just opposite of inflation, which is the general increase in the price level of goods and services. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation. Disinflation is a substantial drop in the rate of increase of the price level. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices.

Inflation destroys real value in money whereas Deflation creates real value in money.
Real Price ~ Nominal Price –Inflation
With the passage of time, the “real price” of any good or service is characterized by above equation. Hence, if it is positive inflation or normal inflation, real price decreases over a period of time. However, if inflation is negative i.e. deflation, real price increases with time. Alternatively, the term deflation was used by the classical economists to refer to a decrease in the money supply and credit.

Causes of deflation
1. Deflation is caused by the fall in aggregate level of demand i.e. there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral. (As we can currently see that buyers believe real estate prices will fall further, thus delaying their purchase decisions. This in turn has reduced the demand for the real estate properties which in turn has reduced the construction activities. Thus, general economic activities such as cement production etc are down.)
As demand and economic activity falls, investments fall as well because corporate do not want to invest in increasing capacity as there is no demand. This leads to further reduction in aggregate demand. This is the deflationary spiral i.e. a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand such as reducing interest rates or giving money to corporate or people at significantly lower rates.

2. In monetarist theory, deflation is related to a sustained reduction in the velocity of money (It is the average frequency with which a unit of money is spent in a specific period of time. Velocity affects the amount of economic activity associated with a given money supply) or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement. In the present scenario it appears to be one of the prime reasons for growing fears of deflation.

3. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

4. Deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply.

Indian scenario – Last few years we saw massive boom in all the sectors. There was huge demand for real estate properties, IT services, Cements, Food products etc. Our economy was growing in excess of 9% and mood was upbeat. Everybody thought this growth will continue forever. Hence, corporate invested heavily in building capacity, developers invested billions of dollars in launching new projects etc. Suddenly the boom busted due to financial crisis. People lost jobs, interest rates went up through the roof and demand plunged. There was a huge mismatch between supply (more) and demand(less). This led to price correction - real estate saw over 40% drop in prices, commodities went down by over 70% and so on. Moreover, due to global financial crisis, there is acute shortage of liquidity in the market and hence less flow of money in the economy. People are holding back to their investments as well as consumption; thus, reducing velocity of money. Does it sound like symptoms of deflation?

Effects of deflation
1. Deflation leads to decrease in prices of good and services, increasing value of money. While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property.
2. Deflation raises real wages, which are both difficult and costly for management to lower. Moreover, falling prices and demand discourages corporations from investing. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment.
3. Deflation often follows a period of nearly zero interest rates. When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.

Why deflation is bad?
While shoppers see falling prices as a good sign, economists see it as a threat to the economy or nation. Deflation hurts the economy much more than inflation. In fact a small positive inflation is good for the economy because it suggests growing demand as well as healthy economy. However, in deflationary conditions consumers postpone expenditure, because they think prices will decrease further. This decreases demand in the economy which badly affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.

I will spend some time to find out the infamous Japanese deflation and impending crisis in the US. Will be back soon.

Exemption from service tax on property sales

The real estate industry has some more news to cheer, as the Central Board of Excise and Customs has issued a circular stating that developers do not have to take up registration or pay service tax on property sales.

The clarification is a step in the right direction, said real estate developers. With banks making interest rates more attractive, construction costs coming down with the prices of steel and cement, and prices also becoming attractive, the timing of this circular is just perfect, they said.

“This decision would definitely benefit purchasers, as they were liable to pay 12.5 per cent tax on 33 per cent of the construction cost, which actually translates to 4.1 per cent of the cost of construction,” said Mr A. Balakrishna Hegde, Former President of Confederation of Real Estate Developers’ Associations of India CREDAI, Karnataka.

The clarification has come after the CREDAI representation to the board that some States insisted that real estate developers undergo registration under the Service Tax Act and pay service tax in respect of residential complex having more than 12 units under the “construction of complex” service. Welcoming the decision, Mr Hegde said: “Our stand has been vindicated.”

Unitech to sell stake, raise $500 m

Unitech Ltd, India's second-largest real estate developer, is looking to raise about $350-500 million (up to Rs 2,500 crore) from a group of foreign investors, in a desperate bid to reduce its debt mountain of Rs 8,300 crore. The company is expected to raise the money by the end of March. Sanjay Chandra, managing director of Unitech, refused to comment. "We would not like to comment on market rumours and speculation".

The company's senior management team, led by founder Ramesh Chandra, is said to be in the tax haven of Cayman Islands in the Carribbean, negotiating the stake deal. Unitech promoters hold 74.56% stake in the company. Sources familiar with the development said the sale of stake is likely to be less than 14.99% so that it does not trigger an open offer.

On Monday, the company announced plans to raise long-term funds up to Rs 5,000 crore through issuance of further securities. Last year, during the boom time, Unitech had planned a qualified institutional placement (QIP) issue for which they had also conducted a roadshow in Mumbai. However, the attempt failed because the Unitech share price was hovering around Rs 650 at point, whereas the company was seeking Rs 750 per share.
Sources said Unitech may be planning a divestment along similar lines. "This may also be because the company's plan to raise about Rs 4,000 crore through distress sale hasn't met with success," said a sector analyst, who did not wish to be named.

"No one goes all the way to Cayman Islands to do a deal but if Chandra is in Cayman then it surely means he will come back with money," said the analyst.It is likely that the stake will be bought not by one but by a group of private equity investors. Earlier in November, Chandra had said Unitech would halve its Rs 8,300 crore debt within 5 to 7 months.