Vivek Kaul
Governments typically spend more than they earn. This difference is referred to as the fiscal deficit. The government of the United States (US) is no different on this front. It has been running fiscal deficits greater than a trillion dollars every year since 2009. It makes up for this deficit by borrowing. It borrows money by selling bonds on which it pays interest.
Currently, the US government has sold bonds close to $16.69 trillion. Of this, around $4.8 trillion worth of bonds have been bought by agencies of the US government which primarily run pension funds and retirement funds. The American households own around $1.2 trillion or around 7.2% of the total outstanding bonds of $16.69 trillion.
This is not surprising given that the savings rate in America has averaged at around 4.6% of the disposable income over the last 10 years. In July 2005, it had fallen to as low as 2% of disposable income. It has since recovered and since the beginning of 2013, it has averaged at 4.4% of the disposable income. The moral of the story is that the average American doesn’t save enough to be able to lend to his government.
So who are the other lenders to the US government? As I explained in detail yesterday the Federal Reserve of United States, the American central bank, is a major lender to the government. Currently it holds bonds worth $2.086 trillion or around 12.5% of the total outstanding bonds of $16.69 trillion.
This lending has gone up by 434% over the last five years. On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion.
The Federal Reserve doesn’t have any money of its own. It basically prints money and uses that money to buy government bonds. This money printing adds to the money supply. This excess money can ultimately lead to high inflation with excess money chasing the same amount of goods and services.
Hence, the Federal Reserve printing money to buy US government bonds is something that cannot continue forever. In fact, Ben Bernanke, had indicated in May-June 2013, that the Federal Reserve will go slow on money printing in the months to come. Since then, he has gone back on what he had said and indicated that the money printing will continue for the time being.
But even with that change in position, the US government cannot continue to rely on the Federal Reserve to finance a significant part of its fiscal deficit by buying its bonds. As I mentioned yesterday, between 2009 and 2012, the US government ran a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
So the question is who will the US government have to ultimately borrow from? The answer is other countries.
As of the end of July 2013, foreign countries held a total of $5.59 trillion of US government bonds. Of this China was at the top, having invested $1.28 trillion. Japan came in a close second, with $1.14 trillion. How has this holding changed over the years? As of September 2008, the month in which the current financial crisis started with the investment bank Lehman Brothers going bust, the foreign countries held US government bonds of $2.8 trillion. Hence, between September 2008 and July 2013, their holdings have doubled (from $2.8 trillion to $5.59 trillion).
Given this, what it clearly tells us is that the foreign countries have helped by the US government run its trillion dollar fiscal deficits by buying its bonds.
Let us look at this data a little more closely. As of the end of December 2008, the foreign countries held US government bonds of $3.07 trillion. By December 2012, this had gone up to $5.57 trillion. This meant that during the period foreign government bought bonds worth $2.5 trillion. During the period the US government ran up a fiscal deficit of $5.09 trillion. The foreign governments financed around 49% of this, by buying bonds worth $2.5 trillion($2.5 trillion expressed as a % of $5.09 trillion).
During this period, some of the bonds that foreign countries had bought would have matured. The US government spends more than what it earns. Hence, it does not have the money to repay the maturing bonds from what it earns. Given this, it needs to sell new bonds in order to repay maturing bonds. A part of these new bonds being sold over the last five years have been bought by the Federal Reserve. The Federal Reserve has done this by printing money.
Hence, the US government has paid for a part of its maturing bonds by simply printing dollars. This is similar to running a Ponzi scheme, where the government is paying off old bonds by issuing new bonds. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
Despite this, foreign countries have been more than happy to buy US government bonds. As we saw a little earlier in this piece, they have doubled their holding of US government bonds between September 2008 and July 2013. In short, foreign countries along with the Federal Reserve have helped the US government to keep running its Ponzi scheme.
Why is that the case? The United States with nearly 25% of the world GDP is the biggest economy in the world. By virtue of that it is also the world’s biggest market where China, Japan and countries from South East Asia and South America, sell their goods and earn dollars in the process.
The way things have been evolved, the US imports and countries like China, Japan, Saudi Arabia etc earn dollars in the process. These dollars can either be kept in the vaults of central banks of these countries or be invested somewhere.
Hence, over the years, these dollars have made their way to be invested in US government bonds, deemed to be the safest financial security in the world. With so much money chasing them, the US government, has been able to offer low rates of interest on them.
This has helped keep overall interest rates low as well. It has allowed American citizens to borrow money at low interest rates and spend it on consuming imported goods. So the Americans could buy cars from Japan, apparel and electronics from China and countries in South East Asia and oil from Saudi Arabia. And so the cycle worked. The US shopped, China and other countries earned, they invested back in the US, the US borrowed, the US spent, China and the other countries earned again and lent money again.
The way this entire arrangement evolved had the structure of a Ponzi scheme. China and other countries invested money in various kinds of American financial securities including government bonds. This has helped keep interest rates low in the US. This helped Americans consume more. The money found its way back into China (like a return on a Ponzi scheme), and was invested again in various kinds of American financial securities, helping keep interest rates low and the consumption going. Like in a Ponzi scheme, the dollars earned by China and other countries has kept coming back to the US.
Hence, foreign countries have an incentive in keeping this Ponzi scheme going. Earlier, it was important for them to keep buying US government bonds to keep interest rates low and help American consume more. It was also important to keep buying these bonds to ensure that the US government had enough money to repay them. Now it has reached a stage, where the US government is repaying them by simply printing dollars.
But even with this foreign countries are likely to continue lending money to the US government by buying its bonds. Sanjiv Sanyal, global strategist, Deutsche Bank Market Research makes this point in a recent report titled Bretton Woods III and the Global Savings Glut.
As he writes “The basic idea is that, when people are young, they have little savings and may even need to borrow in order to spend on consumption and/or build assets. However, as they grow older, their net savings rise as they build up a stock of wealth that is later run down in very old age. The same dynamic can be said to broadly hold for countries as they experience demographic transitions although there are nuances that vary according to cultural context and fiscal incentives of individual countries.”
Basically what this means is that as a country ages (with the average age of its population rising) it tends to save more. Sanyal expects many developing countries to age at a very fast pace over the next two decades. As he writes “The link is even clearer if one considers the pace of aging by comparing the current median age with the expected median age in 2030. For instance, Japan will then have a median age of 51.6 years while China will go from being significantly younger than the US in 2010 to becoming significantly older after two decades. The aging of South Korea is even faster.” He expects these countries to have a median age of 40 by 2030.
Given this, it is likely that as countries age, they will keep generating excess savings. A lot of this money is likely to find its way into the United States, feels Sanyal. As he writes “we know that lenders do not just care about high returns but about policy risk, property rights, corporate governance and the overall ability/willingness to the borrower to return the money. Thus, aging current-account surplus countries may prefer to park their funds in safer countries even though returns are higher in certain emerging markets.”
And this will help the American government to continue borrowing. It will also keep interest rates low and help Americans keep their excess consumption going. “The next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand,” writes Sanyal.
And so the Great American Ponzi scheme might just continue for a while.
The article originally appeared on www.firstpost.com on October 18, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Ponzi Scheme
Debt ceiling absurdity: US Fed will now repay itself by printing money
Vivek Kaul
It was widely expected that the Democrats and the Republicans will finally strike a deal and extend the debt ceiling of the government of the United States(US). And that’s precisely what happened.
A few hours before the US government would have reached its debt ceiling, both the houses of the American Congress, passed a short term bill, allowing the government to suspend the debt ceiling until February 7, 2014. The Senate passed the bill, 81:18. The House of Representatives passed the bill 285:144. The bill will also end the government shut-down in the United States and allow it to operate till January 15, 2014.
Governments around the world spend more than they earn. They make up for the difference by borrowing money. The US government is no different on this front. The only trouble is that it is not allowed to borrow beyond a certain limit. This limit is referred to as the debt ceiling and till yesterday was set at $16.69 trillion.
If the bill suspending the debt ceiling had not been passed, the US government would not have been able to borrow more. And given that it would have become difficult for it to meet its expenditure from its income. Today, i.e. October 17, 2013, the US government will have around $28 billion of cash on hand. The treasury secretary Jack Lew had suggested in early October that expenditure of the US government on certain days could touch even $60 billion.
Given this, it would be able to meet only a part of its expenditure and hence, someone was not going to get paid.
The tricky question for the government would have been to decide who that someone would be. Would the government decide not to pay out the pension cheques? Or would it be unable to pay salaries of its employees? Would it default on the interest payments that are due on its bonds? Or would it be unable to repay maturing bonds? The American government like other governments around the world makes up for the difference between what it earns and what it spends, by selling bonds.
Interest payments of around $6 billion are due before the end of October. Also, bonds worth around $90-93 billion need to be repaid between October 24 and October 31. A default on this front would be catastrophic. The US government bonds (or treasuries as they are more commonly referred to as) are deemed to be the safest financial securities in the world. And if the security deemed to be the safest financial security in the world is not safe, what is?
But these are points that I have made before (you can read them here). The US government’s current debt stands at around $16.69 trillion. It has borrowed this money by selling bonds. Of this nearly $4.8 trillion is held by various agencies of the US government. Most of the US government agencies holding US government bonds are pension funds and retirement funds, which need to make payments in the years to come. To be able to make these payments, they need to invest now. Hence, they invest money in US government bonds deemed to be the safest financial security in the world.
The remaining US government debt of around $11.89 trillion ($16.69 trillion – $4.8trillion) is referred to as the debt held by the public. Of this, foreign nations hold around $5.7 trillion. China holds around $1.28 trillion and Japan $1.14 trillion.
What is interesting is that the Federal Reserve of United States, the American central bank, holds US government bonds worth $2.086 trillion. On the whole, this is only 12.5% of the total US government debt of $16.69 trillion. But what is interesting is that over the last five years the holding of the Federal Reserve has risen by 434%.
On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion. In comparison the debt held by foreign nations has gone up only marginally.
In the last one year, this holding has gone up by nearly $433 billion. What is happening here? The US government is spending substantially more than what it is earning. Since 2009, it has been running fiscal deficits of greater than a trillion dollars. Between 2009 and 2012 the US government ran a total fiscal deficit of $5.09 trillion. In 2013, it is expected to run a fiscal deficit of around a trillion dollars. Fiscal deficit is the difference between what a government earns and what it spends.
In a situation like this, if the US government would borrow all the money from the public, interest rates would shoot up, given that there is only so much amount of money that can be borrowed. And if the government borrows more, then there would be lesser amount of money for others(primarily the private sector) to borrow. This crowding out would lead to a situation where other institutions like banks would have had to offer a higher interest to borrow.
If a bank borrows money at a high rate of interest, it would have to lend it out at a still higher rate of interest, in order to make a profit. Higher interest rates would mean, higher EMIs. This would discourage the average American from borrowing and spending money, something which the US government believes is very important for reviving economic growth.
This is where the Federal Reserve stepped in. It has been buying the bonds being sold by the US government to finance its fiscal deficit. Where does the Federal Reserve get this money from? It simply prints it and hands it over to the government.
As we saw earlier, between 2009 and 2012, the US government has run a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
Hence, the US government financed nearly 23.6% of its fiscal deficit by selling bonds to the Federal Reserve. Federal Reserve handed over this money to the US government by simply printing it. This has helped keep interest rates low in the United States.
And that is the real story. A lot of the US government borrowing over the last few years has been directly from the Federal Reserve. And now that the debt ceiling has been raised, this will continue.
The money that is borrowed by the US government from the Federal Reserve and other sources, is used to fund its expenditure. A substantial part of the expenditure is repayment of past debts as bonds mature, as well as payment of interest on these bonds.
In the year 2012, the US government paid a total interest of around $359.80 billion on its bonds. The fiscal deficit of the US government was around $1.08 trillion. Hence, nearly one third of the fiscal deficit was because of interest rate payments.
The US government does not earn enough to repay maturing bonds. Hence, it has to borrow money to repay bonds. This is a perfect Ponzi scheme where the government is paying off old debt by issuing new debt. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
In fact, as bonds being bought by the Federal Reserve from the US government, come up for maturity they will be repaid by getting the Federal Reserve to print money and buy new bonds. Hence, the Federal Reserve will be printing money to repay itself. If that isn’t absurd, I don’t know what is. The US Federal Reserve is currently helping the US government run its Ponzi scheme by printing money and buying bonds.
Having said that, increasing the debt ceiling was important given that even a whiff of a default would have caused a global financial crisis. First and foremost investors would have started selling out off US government bonds. This would have driven bond prices down and bond yields up, in the process pushing up interest rates first in the US and then globally. This would have put the entire plan of the US government to revive economic growth by maintaining low interest rates in a jeopardy. It would have also led to investors all over the world selling out of various financial markets. The logic would have been that if the security deemed to be the safest financial security in the world is not safe, what is?
Of course, the trouble is that the US government will breach its debt ceiling again in a few months time. What happens then? The debt ceiling has been in place in the US since 1939. Since 1960, the American Congress has increased the ceiling 79 times. So what stops it from doing it the 80th time as well? Nothing really. But till when can this Ponzi scheme go on? Ultimately all Ponzi schemes collapse. The only question is when. And for that I really do not have an answer.
The article originally appeared on www.firstpost.com on October 17, 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)
Dear KC Chakrabarty, here’s the real reason why people invest in Ponzi shemes
Vivek Kaul
A standard explanation that seems to be emerging about why Ponzi schemes keep occurring in different parts of the country is that India does not have enough banks. And this lack of banks leads people to invest in fraudulent Ponzi schemes.
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.
K C Chakrabarty, the deputy governor, is the latest individual who has jumped onto the more banks equals fewer Ponzi schemes, bandwagon. “The fact that people have to rely on such entities for their saving needs indicates a failure on the part of the formal financial system to reach out to such groups and earn their trust and confidence through a transparent and responsive customer service regime,” Chakrabarty said yesterday.
“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,” he added.
So what Chakrabarty is effectively saying is that only if people had a bank in their neighbourhood they would have stayed away from a Ponzi scheme like Saradha. While it simple to come to this conclusion which sounds quite logical, the truth is not as simple as it is being made out to be.
Lets consider a few Ponzi schemes that have done the rounds lately. MMM India which promises to double the investment every month, needs prospective investors to have bank accounts. So here is a Ponzi scheme which is using what Chakrabarty calls the ‘formal financial system’ to flourish.
Before that there was the Speak Asia Ponzi scheme. In this scheme investors needed to fill online surveys. Anyone who has access to internet in India is most likely to have access to a bank account as well. So people who invested in Speak Asia, did so because they wanted to not because they had no banks in their locality.
Then there are Ponzi schemes which involve investments in gold coins. People who can buy gold coins won’t have access to a bank account?
Or lets take the case of Emu Ponzi schemes which had become fairly popular in parts of Tamil Nadu. The pioneer among these schemes was Susi Emu Farms. It promised a return of at least Rs 1.44 lakh within two years, after an initial investment of Rs 1.5 lakh had been made. This was the model followed by nearly 100 odd emu Ponzi schemes that popped up after the success of Susi.
Again anyone who has Rs 1.5 lakh to invest in a Ponzi scheme will not have access to a bank? That is rather difficult to believe. As Dhirendra Kumar of Value Research puts it in a recent column“Could it be that all those people who put money into Saradha wouldn’t have done so if they had a bank in their neighbourhood? Very unlikely. A lot of the deposits seem to have come from towns where there would have been banks. Moreover, almost every ponzi scheme that has come to light in the last few years has actually flourished in towns and cities. The investors who fell for StockGuru or the Emu farms or other schemes all had access to legitimate alternatives.”
So what is it that gets people to put their hard earned money into Ponzi schemes rather than deposit it into banks? The simple answer is ‘greed’. We all want high returns from the investments we make. And Ponzi schemes typically offer significantly higher rates of return than other investment options that are available at any point of time.
Having said that ‘higher returns’ are not the only reason that lures people into Ponzi schemes. There are other factors at work, which along with the lure of higher returns, ends up making a deadly cocktail.
Typically people do not like handing over money to someone they do not know. In small towns, people end up investing money into a Ponzi scheme through an agent they happen to know. So even though they have no clue about the company they are investing in, they feel they are doing the right thing because they know the agent.
In the case of Saradha, agents of Peerless General Finance and Investment were used to collect money. Peerless had a good reputation among the people of West Bengal, having been in the business of collecting small savings since 1932. This helped Saradha establish the trust that it needed to, during its initial days of operation.
As a report in The Indian Express points out “The selection of agents, a crucial link in the chain, was done very carefully by Saradha. Those picked were generally ones who wielded influence in their locality and in whom people had confidence.”
What also helps is the fact that agents are paid reasonably high commissions, leading to a higher level of motivation and thus better service. The agents typically come to homes of prospective investors to get them to invest money. So clearly there is better service on offer unlike a bank. There is very little need for documentation ( PAN No, Address proof etc not required) as well, unlike is the case with a bank.
Let us briefly go back to the more banks fewer Ponzi schemes argument. As the Indian Express report cited earlier states “One important reason for chit funds mushrooming(they are really not chit funds, but Ponzi schemes) in West Bengal is the absence of easy access to banks and other financial institutions. According to an estimate of the state Finance Department, of the 37,000 villages in the state, nearly 27,767 have no bank branch.”
While villages may not have access to a bank, they do have access to post offices. And India Post runs many small savings schemes, in which people can deposit money. But in West Bengal people seemed to have stayed away from these schemes. A report published in December 2012, in The Hindu Business Line quotes Gautam Deb, a former housing minister as saying “small savings and post office collections in West Bengal during the April-October 2012 period were merely Rs 194 crore, against the targeted amount of Rs 8,370 crore.”
So why did people stay away from the post office schemes and get into Ponzi schemes? For one the returns offered on Ponzi schemes were significantly higher. The second reason obviously is the significantly better level of service that Ponzi schemes offer with agents getting higher commissions.
In fact, there are no commissions on offer for selling post office savings schemes. As Kumar points out in his column “The post office offers excellent schemes with a huge reach in rural and semi-urban areas but can it compete on sales and marketing? In fact, when the government eliminated commissions on PPF and other deposits in post offices in 2011, it effectively eliminated whatever little sales muscle there was.”
The formal financial system thus finds it very difficult to compete with unscrupulous operators like Saradha. It is not easy for it to offer higher commissions as and when it wants to simply because it has got rules and regulations to follow. As Kumar puts it “They (i.e. the Ponzi schemes) spend much more on sales commissions, on offices, keeping politicians happy and getting media coverage because they can just dip into the deposited money for all these expenses. Therefore, even if legitimate financial services are available passively, they won’t be able to compete.”
Another reason why the people of West Bengal fell for Saradha was the fact that the Ponzi scheme came to be very closely associated with Trinamool Congress, the party that rules the state. The ‘formal financial system’ cannot afford to do anything like that.
When we take all these reasons into account it is safe to say that the more banks fewer Ponzi schemes argument doesn’t really work. Even if more banks are established, the banks will not be able to compete with the level of service and commissions that Ponzi schemes can offer. Hence, it is very important that unscrupulous operators who are caught running Ponzi schemes are punished and justice is delivered as soon as possible. This will ensure that anyone who wants to start a Ponzi scheme will think twice before he acts. And that is the best way to protect people from Ponzi schemes.
The article originally appeared on www.firstpost.com on May 3, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)