## 2006-09-05

### Perturbation theory, diversion vs dam-building

Professor Steven Cheung wrote in his new piece "Buddha-Mountain's attempt in making Buddha headache" 佛山试制大头佛 describing how the new policy in Foshan (literally, Buddha-Mountain) City in Guangdong, in an attempt to cool the property market, could backfire (in Cantonese, creating a headache for the Buddha).

I will first summarize Cheung's essay, [inserting my own opinion in square brackets]. Then I will make a few brief comments

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Cheung's essay

1) Case of Foshan and Guangzhou

Background: Foshan and Guangzhou recently imposed a price cap on housing projects in certain areas in their cities. RMB3000/m2 for Foshan and RMB6000/m2 for Guangzhou. Granted, the price cap is above the current market prices. But there is still consequence to the market, as the market is not static.

Quiz: If the price is capped below market, what will be the consequences?

1. Auction price for land will be lower, because developers will calculate the price of land they are willing to pay based on the price of apartments they can sell for. However, the auction price will be higher than the theoretical price (i.e. using the cost model, discount rate, assuming the same profit margins, using selling price as input to calculate the cost of land). This is because developers will squeeze the cost of construction/development, including labor, materials, etc. Such "cost control" will very likely lead to low quality of the buildings, perhaps to an extent that safety parameters are compromised
[Another example of price manipulation: if developer wants to price above market, it would have to inject many freebies, such as HK0.5M restauurant/spa coupons in Bel Air Projects of PCCW in HK -S]
2. Since second hand apartments are not under price control, when the market goes up, it is likely that second hand apartments will be priced higher than the caps. However, if the market stays flat, second hand apartment price will not go up. This is because the new units are priced at the market already- the value matches the price as a result of "cost control" in point (1)
[In the former case, developers and insiders may set up affiliate companies and sell all the apartments to these affiliates. The the affiliates will sell to the public at market price. Alternatively, there may be a coupon market for queuing position and right to buy (筹) such that the net price paid by consumer (i.e. including the right to buy) is the market price. In these situations, the prices of the units are slightly higher than the market price had the price cap regulation not been imposed. Because the consumer also pay for the cost of the affiliate/agent arrangements - precsiely the opposite of the intention of the regulators - S]
3. Since the information channel/mediator of the market (i.e. price) has been distorted, the market is not functioning at its optimal efficiency. There will be waste and inefficiencies everywhere
2) Case of Beijing

Background: Beijing is contemplating restricting the number of large size units built, i.e. only 30% of new units can exceed 90m2. In guangzhou, 2 newly auctioned lots already specified that the areas of units cannot exceed 90m2. [Apparently an effort to ensure more supply with the same amount of floor size -S]

Implications:
1. Price drop in medium and small units (under 90m2); rise for large units [supply distorted]
2. Descrease in land price (so will overall wealth of the nation), because the market is distorted and land use is not optimal
3. More units of 90m2 will be build (less of 70-80m2), also more at 130-250m2 cannibalizing on 90-120m2 market segment.
[(a) this illustrates point 2 above of sub-optimum land use (b) developers will respond by building adjacent units of, e.g. 80m2 and 40m2, separated by a cheap and easily torn down wall, and sell them in bundle. Another way that waste of resources is resulted (c) This phenomenon has already be demonstrated by HK's world record in Rolls-Royce and Mercedes-Benz, in per km road or per capita measures, as tariff (and gasoline tax) deems cheap cars less desirable, like the 90-120 m2 units - S]
4. Social stratification more pronounced, as the boundary of social class is characterized by more pronounced market segmentation and is highly visible
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Cheung illustrated in these cases why one should be careful in intervening the market. To be sure, intervention is almost always a bad thing, as you are trying to counter the force of nature, and distort the natural equilibrium/optimum points of the market. Therefore, all directives by human beings are, in reality, perturbations. Once we realize how limited our power is, we know where our strategy should focus on, i.e., "leveraging". This applies to economic, business and even political and military maneuvers.

A good analogy is illustrated by the lesson of Dujiangyan, "Diverting the water flow is always a better solution than building a dam when it comes to flood control". I would illustrate this principle with 2 examples below
1. Cheung's earlier suggestion of a lesser-evil option for discouraging speculative activities with a tax imposed on un-used and un-leased empty apartment unit. The measure is very specific and does not affect the normal market functions, it only discourages profiteering by changing hands, but does not penalize normal transactions based on "need" (i.e. shorting holding period before changing hands, with no tax penalty). However, as Cheung said, it is only a less-evil/second-best option because some of the changing-hand transaction (that could be held ,unexpectedly, longer than planned) are legitimate market activities.
2. China's commodity negotiation strategy (souce: FT): FT reports that China was trying to leverage its volume to bargain for a better price in commodity market. However, volume is only a secondary factor in determining price. i.e. it only works if you have a credible alternative (or if the sellers are really divided). Such tactics are as good as dam building. One plausible "diversion" tactic would be top tackle the issue from another facet, e.g., first negotiate for long term commodity contracts in US\$ and then let the RMB appreciate. (but there are side-effects/implications for RMB appreciation)

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