Vivek Kaul
The Securities and Exchange Board of India(Sebi) in a significant order yesterday directed Rose Valley Hotels and Entertainments Limited (RVHEL) and its directors to stop raising deposits through any of its existing investment schemes. The Sebi also directed RVHEL and its directors not to launch any new schemes, not to dispose of any of the properties or alienate any of the assets of the schemes and not to divert any funds raised from public at large which are kept in bank account(s) and/or in the custody of the company.
RVHEL had launched the Rose Valley Holiday Membership Plan (HMP) sometime in 2010. Under this plan investors could book a holiday package through the payment of monthly instalments. On completion of tenure investors could avail the facilities i.e. room accommodation and other services at one of the RVHEL’s hotels. He or she also had the option to opt for a maturity payment along with interest.
The Rose Valley group started sometime in the mid 1990s and has close to 31 registered companies. It claims to have presence in areas from residential townships to film to media and entertainment.
But a careful study of its operations suggests that it is nothing more than a Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme in which the illusion of high returns is created by taking money being brought in by new investors and passing it on to old investors whose investments are falling due and need to be redeemed.
While every Ponzi scheme is different from another in its details, there are certain key characteristics that almost all Ponzi schemes tend to have. And Rose Valley is no exception to this.
The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors: The website of Rose Valley India claims to be in many businesses like residential townships, commercial complexes, shopping malls, hotels & resorts, amusement parks, garments, IT, Media & Entertainment, Healthcare, Education, Social Welfare, Housing finance, Travels, Films & Fashions.
This told the prospective investors that the company was in various businesses and these businesses were supposedly making money. But there are several questions that crop up here. How did one promoter have the expertise to manage such a diverse line of businesses? We live in a day and age where its not possible for a single entrepreneur to run multiple unconnected businesses profitably.
Vijay Mallya thought running an airline, a cricket team and an FI team was just the same as selling alcohol. DLF thought running hotels, generating wind power, selling insurance and mutual funds would be a cake walk after they had created India’s biggest real estate company. Deccan Chronicle saw great synergy in selling newspapers and running a cricket team and a chain of bookshops. Hotel Leela thought running a business park would be similar to running a hotel. Kishore Biyani thought that once he got people inside his Big Bazaars and Pantaloon shops, he could sell them anything from mobile phone connections to life and general insurance. Bharti Telecom thought that mutual funds, insurance and retail were similar to running a successful telecom business. But in sometime all of them realised that they had a problem.
Of course there are groups like Birlas, Tatas and the Ambanis which are present in multiple businesses. But they are more of an exception that proves the rule.
Rose Valley wasn’t making any money from its multiple businesses either. As a recent report in The Financial Express points out “The Serious Fraud Investigation Office (SFIO) probing Rose Valley Hotels & Entertainment is looking into a web of intra-group transactions including Rs 207-crore loans to promoter Gautam Kundu in 2011-12, sources said. The company reported a loss of Rs 468 crore on revenues of Rs 24 crore in the same year.” On a slightly different note, Kundu travels in a Rolls-Royce Phantom.
Let me repeat this again. The company made a loss of Rs 468 crore on revenues of Rs 24 crore. What this clearly means is that the company wasn’t running any business at all. It was just creating an illusion of having several businesses, so that investors kept coming to it. Meanwhile, it was simply rotating money, using the money being brought in by the newer investors to pay off the older investors. This conclusion can be drawn from the fact that its real businesses weren’t making any money. So the money to pay off the older investors whose investments were up for redemption could only have come from newer investors.
There is other evidence that points to the fact that the company did not have much of a business model. As a January 2011 piece published on www.moneylife.in points out “Under its ‘Ashirvad’ scheme, Rose Valley mobilised Rs1,207 crore by selling 508,792 plots, but handed over only 9,045 plots. While the company claims to have a land bank in several upcoming and industrial areas of West Bengal, the question is, how did they get access to all those vast stretches of land that are traditionally used for agriculture?”
The rate of return promised is high and is fixed at the time the investor enters the scheme: The Sebi order against Rose Valley Hotels and Entertainments clearly points out that returns on various investment schemes varied from anywhere between 11.2% to 17.65%. At its upper the return is significantly higher than the rate of return from other fixed income investments like bank fixed deposits and post office deposits.
The certificate issued for investing in the Holiday Membership Plan said that the money is being invested for booking a room in one of the hotels of Rose Valley, but at the time of maturity the money would be returned against cancellation. This meant that the investors into the Holiday Membership plan could cancel it on maturity and be paid a bulk amount which would include the money invested into the scheme and the interest that had accumulated on it. As the Sebi order points out “However, such investor may also cancel the HMP(Holiday Membership Plan) booking upon maturity or completion of tenure for monthly installments, in lieu of maturity payment for non-utilization of the facilities i.e. the equivalent accumulated credit value under the HMP inclusive of annualized interest.”
An investor who had paid Rs 500 per month for 60 months would get Rs 48,000 if he cancelled at maturity, meaning a return of 17.65% per year. The Sebi order quotes an interim order passed by a sub divisional magistrate in West Tripura. As the Sebi order points out “As per the Interim Order passed by the SDM, West Tripura, RVHEL is alleged to have taken “recourse to unilateral and spontaneous cancellation of bookings of hotels in a routine manner so as to make returns.””
What this tells us is that Rose Valley wasn’t really interested in running the holiday membership plan. It couldn’t possibly have built all the hotel rooms that it had promised to build under the Holiday Membership Plan and hence encouraged investors to opt for a bulk payment on maturity.
Brand building is an inherent part of a Ponzi Scheme: Rose Valley spent a lot of money in building its brand. The company was one of the main sponsors for the IPL team Kolkata Knight Riders (KKR). KKR players wore jerseys with the Rose Valley logo. Rose Valley had a two year sponsorship deal with KKR. For this it paid Rs 5.5 crore during the first year and Rs 6.05 crore during the second year. The deal has now ended. Gautam Kundu, chairman, Rose Valley Group, recently told The Times of India “Our contract was for two years. Now it’s for me to decide whether I shall renew it or not. The decision to invest in KKR will also be mine, entirely.”
This deal helped Rose Valley build more credibility among prospective investors in West Bengal where it is primarily based out of. As Ashok Mitra, a retired clerk with the state government told New York Times India Ink “I saw Shah Rukh Khan(one of the owners of KKR) and invested 75,000 rupees…I did not worry because he was vouching for the company.”A report that appeared in The Indian Express in May 2013 quoted a source as saying “The company joined hands with KKR because they wanted to build their image and extend their reach. With 254 branches across the country, the association with the KKR provided them the right platform.”
Rose Valley has significant presence in the media. It owns newspapers as well as television channels. It also used other newspapers to build its brand. As the Moneylife article cited earlier points out “Rose Valley has been a big advertiser with Ananda Bazar Patrika (ABP) group. ABP has gone out of its way to promote them and celebrate their “entrepreneurship”.”
The most important part of a Ponzi Scheme is assuring the investor that their investment is safe: This is the most tricky part about running a Ponzi scheme. Unless the investor feels assured that his money will be safe he won’t invest it in the scheme. Rose Valley was a corporate agent of the Life Insurance Corporation(LIC) of India between 2002 and 2011. It is said that Rose Valley used this route to raise money for its own investment schemes. Given this, the confidence that people have in LIC which is backed by the government of India would have rubbed onto Rose Valley as well.
Interestingly, the Insurance Regulatory and Development Authority(Irda), the insurance regulator, cancelled Rose Valley’s license in early 2012.
To conclude, it is important to know that on March 14, 2013, Sachin Pilot, the Union Minister of State for Corporate Affairs, presented a long list of companies across the country against which complaints had been received for running Ponzi schemes. This list had 14 companies belonging to the Rose Valley group.
The article originally appeared on www.firstpost.com on July 11, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Ponzi
Is the Chinese credit bubble starting to unravel?
Vivek Kaul
One of the fundamental rules of forecasting is to make as many forecasts as possible and then publicise the ones you get right. A little over two weeks back I wrote a piece titled “Is China getting ready for the next big financial crisis?”
On June 24, 2013, the Shanghai Composite Index, China’s premier stock market index fell by 5.3% to close at 1963.22 points. The fall continued on June 25, and at one point of time the index reached a four year low of 1849.65 points. Though by the end of the trading day, the stock market had managed to recover the losses and was quoting at around 1960 points.
The stock market plunged in response to the Shanghai interbank offered rate (or Shibor) going up dramatically towards the middle of last week. Shibor is the interest rate at which banks lend to one another. It had spiked to 25% on June 20, 2013.
Despite this rapid rise in Shibor, the People’s Bank of China, the Chinese central bank, refused to intervene. In fact in a statement dated June 17, 2013 (but issued only on June 24, 2013) the central bank said “current liquidity in our country’s banking system is overall at a reasonable level.”
This statement was what caused a panic in the stock market on June 24, 2013. The interpretation was that the People’s Bank of China was sending out a message that the days of “easy money” in China are over and the central bank would now get into a tightening mode as far as the easy availability of credit was concerned. If one were to use the language of those who follow every move that a central bank makes, the central bank had just turned hawkish. The stock market falling was a response to that.
Loans given by banks and other financial institutions have grown at a very rapid rate since 2007. As Edward Chancellor and Mike Monnelly of the global investment management firm GMO point out in a white paper titled Feeding the Dragon: Why China’s Credit System Looks Vulnerable “Between 2007 and 2012, the ratio of credit(i.e. loans) to GDP climbed to more than 190%, an increase of 60 percentage points. China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.” As of the end of 2012, the total lending by banks and other financial institutions as a proportion of the GDP ratio stood at 198%. And this growth in loans continued unabated even in 2013. During the first three months of the year, the loans grew by 20% in comparison to the same period last year.
Ambrose Evans-Pritchard of The Daily Telegraph comes up with a very interesting data point in a recent blog which shows very clearly how big the Chinese credit bubble really is. As he writes “China has increased credit from $9 trillion to $23 trillion since late 2008. The increase is equal to the entire US commercial banking system.”
This lending by banks and other financial institutions is reflected in the rise of private sector debt in China. A recent World Bank report puts the ratio of private domestic debt to GDP at 160%. This is the highest among all the nations categorised as emerging markets. The credit rating agency Fitch puts this ratio at 200%.
This rapid increase in credit, which has had the blessing of the People’s Bank of China, has been a major reason behind China continuing to grow at a very high rate even though economic growth all over the world has slowed down.
But the trouble is with so much money being lent, the efficiency of lending has broken down i.e. more money has to be lent now to create the same amount of growth, in comparison to the past. As Wei Yao of Societe Generale writes in a report titled China’s missing money and the Minsky moment “a fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both. There is clear evidence that China is suffering from both of these.”
Wei Yao estimates that China has “a shockingly high debt service ratio of 29.9% of GDP, of which 11.1% goes to interest payment and the rest principal….At such a level, no wonder that credit growth is accelerating without contributing much to real growth!”
In fact so much money has been lent that ghost cities where no one lives have been built. “Miles upon miles of half-completed apartment blocks encircle many cities across the country. Official data suggest that the value of the unfinished housing stock is equivalent to 20% of GDP and rising..Developments in the infamous “ghost city” of Ordos, in Inner Mongolia, reveal the vulnerability of China’s credit system to an overblown housing market. The Kangbashi district of Ordos is a totem for China’s property excesses. Kangbashi has enough apartments to shelter a million persons, roughly four times its current population,” write the GMO authors.
A lot of these loans have (and continue) to be made in the shadow banking system. As an article in The New York Times points out “Banks borrow at the low interbank rate, then lend to trust companies and smaller banks who in turn make riskier loans. The fear among some analysts is that the vast amount of bad debt and hidden liabilities the shadow banking system masks could start sinking banks. Those excesses could start a chain of other economic setbacks.”
Money raised and lent by the shadow banking sector has also been responsible for the massive property bubble in the country. As an article in the LA Times points out “Chinese authorities are trying to rein in the nation’s so-called “shadow banking” sector, in which smaller banks and trust companies borrow from bigger state-run banks with easy access to credit. Those entities relend money at high interest rates to property developers and businesses, often with tight connections to the Communist Party, driving speculation and asset bubbles.”
And the People’s Bank of China cannot let this run forever. Hence the recent statement is being seen as a warning to banks and other financial institutions to go slow on lending money. Also Shibor, acts as a benchmark interest rate to other kind of loans from home loans to credit cards. And a rise in Shibor could slowdown lending further. As Goldman Sachs said in a recent note “The recent tightening of the interbank market has sent a strong policy signal that the strong credit growth earlier in the year will likely not continue.” For any bubble(and China has a huge property bubble that is currently on) to sustain itself it is important that money keeps coming in. And the Chinese central bank seems to have turned the tap off as far as “easy money” is concerned.
Another possible explanation is being offered for the recent hawkish statement made by the People’s Bank of China. The new Chinese President Xi Jinpingand Premier Li Keqiangare said to be interested in initiating financial sector reforms by opening up the Chinese bond markets and also freeing up the interest rates.
The Forbes quotes Carl Walter, who has spent 20 years working in Chinese banking sector as saying “There is a political message to all of this, which is don’t mess with the banking system…I think the People’s Bank of China and the big four banks are telling the new leadership to keep its hands off this sector.”
By letting the Shibor to rise, the banking interests want to show the new Chinese leadership of what is likely to happen if the interest rates are set free. As Walter puts it “By playing with Shibor, letting it go sky high, and watching these small banks squeal then politically you show strength…They are saying, ‘you want to liberalize interest rates, go right ahead, look what at what is happening to these smaller banks. We are too big to fool around with.”
Either ways, there is trouble ahead.
The article originally appeared on www.firstpost.com on June 26, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Why Amway case is similar to a ponzi scheme
Vivek Kaul
William S Pinckney, the chief executive officer of Amway India, was arrested yesterday by the crime branch of Kerala Police along with two other directors of the company.
A report in the Daily News and Analysis (DNA) quotes a top official of Economic Affairs Wing (EOW), Kerala as saying “With the call of easy money, they have been luring people to come and invest. And in turn, the new members had to get more people and this was leading to illegal money circulation. As a result, we had received several complaints against the company and we decided to arrest the officials.”
The company is said to have been violating the Prize Chits and Money Circulation Schemes (Banning) Act. More specifically, Pinckney and the two other directors were arrested in connection with a case filed by a certain Visalakshi of Kozhikode. She claimed to have incurred losses of Rs 3 lakh in trying to sell the products of Amway through its multi-level marketing network.
A report in The Mint quotes P A Valsan of the EOW of Kerala Police as saying “They were charging 10 times the value of their product. For instance, they sold product priced at Rs 340 at anywhere between Rs 2,700 and Rs 3,400…Also, they were involved in money chain, which is prohibited under the Prize Chits and Money Circulation Schemes (Banning) Act 1978.”
So there are multiple reasons behind the arrest. It is for the Police and the Courts to establish whether the products were being sold at many times their price. But the other part about whether Amway is a money circulation scheme or not, needs some discussion.
A money circulation scheme is essentially a Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
Before we get into a detailed discussion on whether Amway is a Ponzi scheme or not, it is important to understand how Amway and other multi-level marketing(MLM) companies go about their business.
An MLM company like Amway appoints independent distributors to sell its products. Amway sells products like diet supplements, toothpastes, shampoos, multi-purpose liquid cleaners, soaps, grooming products etc. These distributors are not employees of the company. They make money by selling Amway products.
As per the Amway Business Starter Guide there are three ways a distributor can make money. First and foremost he makes what the company calls the retail profit margin. “Distributors buy Amway products at Distributor Acquisition Price (DAP) and may resell products at a retail price, not to exceed the maximum retail price, as published. In this case, the Distributor’s income would be the difference between the DAP and retail price,” the Business Starter Guide points out.
This is the way almost any distributor for any company makes money. He buys goods directly from the company at a certain price and then sells them at a higher price, which cannot be more than the maximum retail price.
The second way a distributor makes money is through what Amway calls the commission on personal purchases. “Distributor may earn commission on the volume of the Distributor’s individual purchases of Amway products during the month,” the Business Starter Guide points out.
The third way a distributor makes money is through earning commissions on group sales. “A Distributor may recruit a sales group and based on the success and productivity (as defined by product sales) of the sales group, a Distributor may earn commissions. It is important to note that a Distributor only earns commissions on the volume of Amway products actually sold,” the Business Starter Guide points out. So a distributor can sponsor other distributors and then make a certain commission on the amount of Amway goods sold by those distributors. The new distributors can appoint more distributors and so the chain grows. The original distributor gets a commission on all the products sold under his chain.
Prima facie this sounds like a perfectly legitimate though not a normal way of doing business. Amway products are not available in shops. If you want them, you have to buy them directly from Amway distributors.
There are many multi-level marketing companies in the market which claim to sell a certain product. These products include gold coins, holiday memberships and so on. These MLM companies appoint distributors who in turn appoint new distributors, with the idea of selling the product of the company.
The catch here is that the product is just a façade. Nobody really interested in selling the product. The money is made by distributors by appointing new distributors who are a charged a certain commission for joining the MLM scheme. The new distributors in turn appoint newer distributors and so the chain continues.
The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels. So these MLM schemes are essentially Ponzi schemes where money being brought in by newer distributors is paid off to older distributors. There is no legitimate business activity going on.
The Federal Trade Commission in the United States looked at Amway in the 1970s and tried to answer the question whether Amway was a legitimate business or a Ponzi scheme? The Commission held that, although Amway had made false and misleading earnings claims when recruiting new distributors the company’s sales plan was not an illegal pyramid scheme (another name for a Ponzi scheme). “Amway differed in several ways from pyramid schemes that the Commission had challenged. It did not charge an up-front “head hunting” or large investment fee from new recruits, nor did it promote “inventory loading” by requiring distributors to buy large volumes of nonreturnable inventory,” said Debra A Valentine, a general counsel for the FTC, in a seminar organised by the International Monetary Fund in May 1998.
So that’s another point in favour of Amway not being a Ponzi scheme.
But there is one thing that we need to understand here. Like in an MLM scheme which is a Ponzi scheme, the business that an Amway distributor does, depends on finding new distributors and then hoping that these new distributors sell Amway products and at the same time are able to appoint newer distributors. If a distributor is successful at this he makes more and more money.
The trouble is that we go along it becomes more difficult to appoint new distributors. Lets t
ry and understand this through an example. Lets say the first distributor that a genuine MLM company appoints, in turn appoints five distributors.
These five distributors now appoint five distributors each. So we now have 25 distributors at the second level. Each of these distributors now in turn appoints 5 distributors.
So we now have 125 distributors at the third level. If the chain continues, at the 12th level we will have around 24.45 crore distributors. This is equal to around 20% of India’s population. The total number of distributors will be around 30.51 crore.
What this simple example tells us is that it is difficult to keep appointing more and more distributors. This is similar to a Ponzi scheme, where for the scheme to keep going more and more newer investors need to keep coming in, so that the older investors whose money is falling due can be paid off. The trouble of course is that that the number of people is not infinite, as the above example shows us.
The problem for Amway distributors (or any other genuine MLM company) entering the game late is that it is difficult for them to sponsor new distributors. It is also difficult for them to sell Amway products given that there are so many distributors already operating in the market and they have selling relationships in place. Also, products sold by MLM companies typically tend to be more expensive than similar products being sold in the open market, making it more difficult to get customers willing to buy.
Hence, even in a legitimate MLM business like Amway, it is important to enter early. Those entering the business at the lower levels, find it difficult to get on new distributors and also end up with a lot of unsold inventory, thus leading to losses.
Amway requires its distributors to buy back unsold inventory from the new distributors that they sponsor. But that is easier said than done.
To conclude, an individual entering a legitimate MLM business at lower levels is likely to face losses and be unsuccessful at it. To that extent, even legitimate MLM businesses are similar to Ponzi schemes, where it is important to enter the scheme early. Also, like Ponzi schemes even legitimate MLM businesses project the prospect of unrealistically high returns while soliciting new distributors.
The article originally appeared on www.firstpost.com on May 28,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Decoding the great Indian real estate ponzi scheme
Vivek Kaul
A headline can sometimes tell you the complete story. The May 20, 2013, Hindi edition of the Business Standard had one such headline. “Intehan ho gayi intezar ki, aayi na kuch khabar ghar bar ki (Its been a long time waiting, and there is still no news of the house),” went the headline.
The headline was a play on the hit Amitabh Bachchan-Kishore Kumar song “Intehan ho gayi intezar ki, aayi na kuch khabar mere yaar ki (Its been a long time waiting, and there is still no news of my love) ,” from the movie Sharabi.
The story which appeared in the English edition of Business Standard as well with a rather drab headline ‘Supply blues persist in realty sector‘, basically made two points:
a) More and more real estate companies were delaying the promised delivery of homes due to various reasons. As the story pointed out “The year 2013 was projected as the year of delivery for residential projects which had been stuck for years. While developers claim they are on course to supply a large number of units this year, sector watchers doubt it.”
b) This delayed delivery had not stopped real estate companies from announcing and launching new projects. As the story pointed out “Notwithstanding the delays in ongoing projects, a number of real estate companies, including DLF, Unitech, SVP and Supertech, are going ahead with launches, to generate cash flow in a tight market situation.” What this means is that people who have paid for homes continue to wait, whereas the real estate companies continue to launch new projects.
These two points basically tell us very clearly that the Indian real estate sector has degenerated into an out an out Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
The important point here to remember is that in a Ponzi scheme the money being brought in by newer investors is used to pay off the older investors whose investment needs to be redeemed. Lets apply this in the context of real estate companies and understand why they have become Ponzi schemes.
The real estate companies have offered various reasons for the delay in delivery of homes. “Builders cite several reasons — not getting requisite approvals, slowdown in the market, land acquisition and farmers issues, among other,” the Business Standard points out.
Anyone who is not familiar with the way Indian real estate companies work would be surprised at this. You would expect a company to have sorted issues like land acquisition and getting the requisite approvals before a project is launched. If there is no land where will the homes be built? If there are no permissions how is the real estate company going to get around building the homes? And given this why is a project even being launched?
But typically this is not how things work (at least in large parts of Northern India, and particularly in and around Delhi). The real estate company first launches a project, collects money for it, and then gets around to acquiring the land and getting the permissions in place. And once it has raised some money, only then does it finally getting around to building homes. So when a real estate company says that homes have not been delivered due to these reasons, then they are largely true though not fair on those who have bought homes hoping to live in them.
However, that is just a part of the problem. The real estate companies loaded up on debt during the few years running up to 2008. Money back then was cheap and the possibilities of what you could do with it were endless.
Take the case of DLF, India’s largest listed real estate company. It had a net debt of Rs 21,350 crore as on December 31, 2012. Interest needs to be paid on this debt. At the same time this debt needs to be repaid as and when it matures.
But the slowdown in the real estate market due to the high prices has ensured that these companies are not selling enough to be able to repay these debts. In case of DLF, the sales for the period between April 1, 2012 and December 31, 2012, were down by 9% to Rs 6,777 crore.
What has happened because of this is that companies are using money that has been raised for new projects to pay off interest on debt as well as repay debt. Hence, there is no money left to build homes. In this situation, the only way left for the company to raise more money to build homes, is to launch newer projects. It can also hope to raise money from big private money lenders, where the interest can be as high as 3-4% per month. So launching newer projects is an inherently cheaper way of raising money.
So the money lets say raised for Project A is used to pay off interest on debt and repay debt that is maturing. To build homes that have been already sold under Project A, a Project B is launched. This money is now used to build homes for Project A, assuming its not used to meet debt payments. So, this ensures that Project A is delayed. Now to build homes promised under Project B, a Project C is launched. And so the cycle continues.
So money being brought in by investors into Project B is being used to build homes for Project A. Money being brought in by investors into Project C is being used to build homes for Project B. A perfect Ponzi scheme is one where money brought in by the newer investors is used to pay off older investors. In this case money brought in by newer investors is used to build homes for older investors.
The important part here like any Ponzi scheme is that it will keep running as long as the money keeps coming in. And the money will keep coming in as long as people continue to have faith in real estate as a great investment that has given fabulous returns in the past.
This faith is built on various myths. The biggest myth is that India has a huge population and hence a large amount of land will be required to house this population. And land is scarce. As the great American writer Mark Twain once remarked “Buy land, they’re not making it anymore”.
Given this scarcity of land, real estate prices will only go up. The argument though doesn’t quite hold against some basic number crunching. As economist Ajay Shah wrote in a recent piece in The Economic Times “Some claim that India has a large population and there is a shortage of land. A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
But as they say perception is reality. And given this money keeps coming into the Indian real estate sector. What helps in keeping this perception going is the fact that politicians have their black money invested in the real estate sector and it is in their interest to ensure that real estate prices do not fall.
One way of doing this is having some sort of a control on supply of new homes. The best way to do this is having a low FSI, which ensures that real estate companies cannot build enough to meet demand. As Shah points out “The biggest story about the future of real estate prices in India is the FSI. In most of India, the FSI is below 2. This is an abysmally small number by global standards. All over Asia, FSIs are above 5, going up to 20 or to no limit….A higher FSI results in lower rental rates for households and firms, as was seen in Hyderabad which was a pioneer in FSI reform. When FSI goes up, this will unleash supply on a big scale. As an example, if Bombay(the city is now called Mumbai) moves from an FSI of 1 to 2 — which would still make it worse than the FSI seen anywhere else in Asia — this would trigger off a doubling of supply.”
The other way politicians ensure that real estate prices continue to remain high is by nudging the banks to give newer loans to cash starved real estate companies. As Ajit Dayal wrote in a column in 2009 “Their act of giving the loan to real estate developers gives them badly needed cash. The real estate developers no longer need to sell their real estate to get “cash flow” to stay alive.”
If at that point of time banks hadn’t bailed out real estate companies, they would have had to sell homes at lower prices, and real estate prices would have thus come down. And that would have meant lower returns for real estate investors. This would have led to the real estate Ponzi scheme that is in operation breaking down because investors would have had some doubts before parking more money in real estate. But that was not to be.
What is interesting is that loans that banks give to what the Reserve Bank of India calls commercial real estate(i.e. to companies and not individuals buying homes) continues to grow at a much faster rate than overall bank lending.
Given these reasons, real estate companies will continue to launch new projects and delivery of homes will continue to be delayed.
The article appeared originally on www.firstpost.com on May 22, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Of Subbarao, inflation, gold and Saradha scam
Central bank governors rarely indulge in any plain speak. You have to always read between the lines to understand what they are really saying. They never say what they mean. And they never mean what they say.
But D Subbrarao, the governor of the Reserve Bank of India, indulged in some plain speaking on Wednesday and questioned the logic of the Mamata Banerjee government in West Bengal setting up a Rs 500 crore relief fund to compensate the losses of those people who had invested in deposits raised by the Saradha Group in West Bengal.
A part of this relief fund will be funded by a 10% tax on cigarettes and the rest of the money will be raised through other sources. “If you go back to the West Bengal Saradha scheme, the Chief Minister said ‘I will levy additional taxes on cigarettes and some other things to compensate the people who have lost money’ … Is it fair?” Subbarao asked.
Why should people who smoke fund those whose money has gone up in smoke, is a reasonable question to ask. It is like robbing Peter to pay Paul.
Subbarao also dwelled into why Ponzi schemes like Saradha have become fairly popular. “The reason it (the Ponzi schemes) is happening because ordinary people… the low income people are not sufficiently aware of where they can put their money. They don’t have enough avenues to put their money. They can’t get into the banks like we all do. They face both formal and informal barriers…So they fall prey to these fraudulent schemes,” Subbarao explained.
This is an explanation similar to the one his deputy K C Chakrabarty had come up with a few days back when he said: “The need of the hour is to ensure that our unbanked population gains access to formal sources of finance, their reliance on informal channels and on the shadow banking system subsides and, in the process, consumer exploitation is curbed.”
This is a very one-dimensional explanation of why Ponzi schemes have become so popular in India in the last few years. Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
This writer has explained in the past that lack of a bank in their neighbourhood is not a reason good enough to explain why people invest money in Ponzi schemes. Many of the Ponzi schemes over the last few years have been very popular in urban as well as semi-urban areas, where there are enough number of banks going around. At the same time some of the Ponzi schemes have even needed bank accounts to ensure participate. So saying that people invest in Ponzi schemes because there are not enough banks going around, is not good enough. There are other bigger factors at work.
Ponzi schemes have become a big menace in India over the last few years. There numbers have gone up many times over. While there is no hard data to support the claim, but there is enough anecdotal evidence going around. Be it Speak Asia or Stock Guru or MMM India or Emu Ponzi schemes etc, there has been endless list of Ponzi schemes hitting the market.
This has also been a period of high inflation where interest offered on fixed deposits and postal savings deposits, has been very low or even negative once it is adjusted for inflation. There are other reasons as well why people find fixed deposits and postal savings deposits unattractive.
As Ila Patnaik wrote in a recent column in The Indian Express “Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.”
It has been an era where bank fixed deposits have offered around 9% interest before tax when the inflation has been at 10% or more. The returns from post office savings deposits have been even lower than bank fixed deposits. Hence, in the strictest sense of the term, money deposited in banks or post office, has essentially been a losing proposition, given the high inflationary scenario that has prevailed.
And not surprisingly in this situation people have been looking at other investment avenues where there is a prospect of making higher returns. Gold has been one such investment avenue. As the Economic Survey released by the government in late February this year pointed out “Gold imports are positively correlated with inflation. High inflation reduces the return on other financial instruments… This observation, in line with global trends, is easily explained by the declining real returns on the gamut of financial instruments available to the investor and soaring ones on gold (23.7 per cent annual average return between April 2007 – March 2012 versus 7.3 per cent return on Nifty and 8.2 per cent on savings deposits).”
So money came into gold because there was a prospect of earning a high real return instead of bank and post office deposits where the individual would have actually lost money after adjusting for high inflation.
A similar explanation can be offered for people investing their hard earned money in Ponzi schemes like Saradha. They were looking for a higher return which helped them at least beat the rate of inflation. And this is where Ponzi schemes like Saradha came in. These schemes offered deposits which promised higher returns than bank or post office deposits.
As an article in the Business Standard pointed out “Sen(in reference to Sudipta Sen who ran Saradha) offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.”
In case of Saradha, the credibility it had built through its media empire as well as being seen closely aligned to the ruling Trinamool Congress, also helped. The deposits being raised may have even been seen as very safe, by those investing.
The other thing that has happened over the last few years is that household savings have come down. In 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010), savings stood at 25.2% of the gross domestic product (GDP). In 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) the savings had fallen by nearly three percentage points to 22.3% of the GDP.
This has primarily happened because of high inflation which has pushed up expenditure as a proportion of total income. But incomes haven’t gone up at the same pace. And this has led to a fall in savings.
Given that savings of people have come down, there might be a temptation to invest them in avenues where they thought a higher return could be earned so as to ensure that investment goals continue to be on track, even with a lesser amount of savings being invested. This might have increased people’s appetite for taking on investment risk.
Hence, high inflation may have had a big role to play in people investing their money in Ponzi schemes. And we all know who is to be blamed for that.
Inflation has had Subbarao worried for a while now. “There is an important constituency in the country that is hurt by inflation. Their voice also needs to be heard. It is the responsibility of public policy institutions like the Reserve Bank to go out of our way and listen to silent voices,” the RBI governor said on Wednesday.
To conclude, it is very easy to argue that more Ponzi schemes spread because people people lack access to basic banking. But the reality is a little more complicated than that. As they say, truth is often stranger than fiction.
The article originally appeared on www.firstpost.com on May 9,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)