Before starting any formal
discussion on bubbles, I would like to define what a bubble actually is.
The term “bubble” is widely used but rarely defined, probably because it is hard
to define. A working definition for the purposes of this note is: a bubble is an
episode in which irrational thinking or a friction causes the price of an asset
to rise to a level that is higher than it would be in the absence of the
friction or the irrationality; and, moreover, the price level is such that a
rational observer, armed with all available information, would forecast a low
long-term return on the asset.
So according to this definition, do we have a bubble in the property market of
Pakistan?
Prior to the year 2000, the house price was increasing on a stable rate, but
post 2000, it just started to increase very rapidly. There are many reasons for
it, one is the huge demand from a huge population, but that alone cannot explain
the huge advances.
People in Pakistan are now investing in property on a very large scale, some
people can only afford to buy one house with the savings of their whole life.
But there are others who are buying portfolio of domestic and commercial
properties to make a profit, because property gives you the best return, this is
the prevailing mind set in Pakistan.
And now people have more opportunities to invest in properties with the advent
of property market giants, who are building on a massive scale to cater to
investors in the property market. Bahria Town, which is probably the biggest
property developer of Pakistan has a huge network of property dealers who invest
in various projects of Bahria Town, these dealers get the money from people who
want to invest in property projects in various parts of Pakistan. Recently,
Bahria Town has accumulated huge amounts of monies, by booking plots in Bahira
Town, Karachi, many people are booking more than one plots because they are
expecting an increase in price in future.
So this kind of investment is on full throttle in Pakistan by the general
public. It’s not necessarily a bad thing, as this brings the much needed
investment in the property market, but we have to see the broader picture with a
grain of salt.
All these investors are investing with a hope of profits, what if property
market crashes, who will bear the cost then. The reason of the recent financial
crises in the whole world was just a property market crash, which brought the
whole economy down with it.
Behavior Finance research shows many reasons for this bubble formation in any
kind of market. First is that investors extrapolate past outcomes – returns,
earnings growth, or default rates -- too far into the future (Lakonishok,
Shleifer, Vishny, 1994; Barberis, Shleifer, Vishny, 1998; Greenwood and Hanson,
2010). This assumption is usually motivated by Kahneman and Tversky’s (1974)
representativeness heuristic. According to this heuristic, people expect even
small samples of data to reflect the properties of the parent population. As a
result, they draw overly strong inferences from these small samples, and this
can lead to over extrapolation.
One theory of bubble formation is based on overconfidence -- specifically, on
the idea that people overestimate the precision of their forecasts (Daniel,
Hirshleifer, Subrahmanyam, 1998). According to this theory, when investors, in
an effort to estimate an asset’s fundamental value, gather and analyze
information, they become overconfident about the usefulness of this information.
For example, if they uncover favorable information about the asset, their
overconfidence about how reliable the information is leads them to push the
price of the asset up too high.
Another theory, argues that, after investors experience gains in their holdings
of an asset, they become less risk averse because of a “house money” effect: in
short, having experienced gains, they are less concerned about future losses
because any losses will be cushioned by the prior gains. Their reduced risk
aversion leads them to buy the asset even more enthusiastically, thereby pushing
its price up even further (Thaler and Johnson, 1990; Barberis, Huang, Santos,
2001).
So which one applies to us in Pakistan?
People in Pakistan are definitely extrapolating past returns to far in future,
nobody is willing to think about a possibility that property price may fall
future. Investors are definitely overconfident after making some gains on their
initial investments as well. So we might have a bubble in the property market,
one thing in our favor is that banks are not giving huge loans to the investors
to invest in the property market, because our banks cannot securitize their
loans with triple A ratings from the top rating agencies, which they can then
shove to the global investors.
So the situation might not be alarming, but sooner or later, the property market
bubble will burst, we have an infant economy and something like that would be
hard to deal with. So perhaps we better pay some attention.