Charles Ponzi, an Italian, who landed in the United States, attained immortality with what is now called the Ponzi Scheme.
The year was 1919 and during the course of launching an export magazine, Ponzi realized that a huge arbitrage opportunity existed because the international postal reply coupons did not seem to follow the law of one price.
Ponzi started an investment scheme to cash in on this arbitrage opportunity and promised to his investors that he would double their money in ninety days. At its peak, the scheme had 40,000 investors, who had invested around $15 million.
On the August 10, 1920, the scheme collapsed. Ponzi's scheme ran into execution problems. He created an illusion of a successful business by using the money brought in by new investors to pay off the old investors.
Essentially the capital of the scheme was used to pay interest. Since then many such schemes have appeared in India and abroad.
A few famous Ponzi schemes in the Indian context were Anubhav Plantations, Home Trade, the CRB scam, the Ashok Sheregar schemes in Mumbai, non-banking financial companies, chit funds, etc. The intention of all of these schemes was to defraud investors of their money.
However, not every Ponzi scheme starts out with the intention of defrauding investors. The institutions of Government of India have run some of the biggest Ponzi schemes in India in the past.
The Unit Trust of India's erstwhile flagship scheme Unit Scheme-64 (US-64) seems to fit the bill perfectly. What was a successful legitimate business over the years degenerated into a Ponzi scheme. US-64 paid out huge dividends to its unit-holders without revealing the actual NAV (net asset value) of the scheme.
Over the years the dividends paid out were larger than the income of the trust. For this the trust had to dip into its reserves. Soon the reserves also ran out.
So the Trust started paying out dividends not out of earnings, but out of the money that new investors brought in (US-64 was an open ended fund, the investors could get in and get out of the scheme anytime they wanted to).
A fund, which symbolized trust, degenerated into a Ponzi scheme. Investors continued to participate in this Ponzi scheme because US-64 had acquired a 'too big to fail status.'
Since a large number of investors were involved, assets of the state were used to organise for a bailout. Logically, since the ownership of the state's assets is distributed evenly between all citizens, the bailout amounted to a redistribution of wealth from non-participants to participants.
The government does not seem to have learned from its past mistakes and seems to continue to support more Ponzi schemes.
Employees Provident Fund
The Employees Provident Fund (EPF) scheme was started in 1952. The participation was made mandatory for private and public enterprises in 177 specified sectors.
The EPF has investments of Rs 102,747 crore (Rs 1,027.47 billion). At the existing interest rate of 8.5 per cent, the EPF must generate Rs 9,163 crore (Rs 91.63 billion) to keep up with times.
Of the total investments, nearly 79 per cent is invested in the special deposit scheme (SDS) of the central government, which pays 8 per cent. So the investment in SDS is generating an income of Rs 6,494 crore (Rs 64.94 billion) per year.
This means that the remaining 21 per cent of investments has to generate Rs 2,699 crore per annum. This implies a return on investment greater than 12 per cent. Given the fact that present regulations allow a maximum of only 10 per cent of assets to be invested outside government securities, generating a return greater than 12 per cent becomes next to impossible.
So the EPF is essentially using its capital to service returns that fall due, which makes it somewhat of a Ponzi scheme.
Now imagine the situation if the government were to bow to the demand of the Left parties and increase the interest rate further. The 21 per cent of capital not invested in SDS would have to generate even greater returns, which would not be possible given the present structure of the scheme.
So the EPF will have to use more capital to service present returns, thereby increasing the Ponzi nature of the scheme.
Public Provident Fund
The Public Provident Fund (PPF) was started in 1968 with the aim of helping informal sector workers to save for their retirement.
After more than three decades of existence, PPF covers only around 1 per cent of the Indian workforce and to top it, it's more a Ponzi scheme than anything else. PPF guarantees a return of 8 per cent. PPF works on a pay as you go (PAYG) system. In a PAYG system, investments of later investors are used to finance the returns to be given to earlier investors.
Money invested in PPF goes into the revenues of the government and is spent as usual. When returns fall due, the money comes out of the revenues of that particular year.
An asset corpus with Individual Retirement Accounts (IRA) is not build up. All this makes PPF a Ponzi scheme.
Small savings schemes
Small savings schemes are backed by the central government but the money received net of redemptions goes to the states. The states repay the Centre over a period of 25 years.
These small savings schemes have a maturity mismatch when it comes to repayment obligations. This has led to a situation wherein half of the new collections are used for redemption of the previous deposits. This makes small saving schemes in India Ponzi schemes.
Economists admired the erstwhile finance minister Jaswant Singh's decision to cut interest rates on these government-backed saving schemes by one percentage point. But they wanted the minister to do a little better than this.
The Ponzi nature of such schemes might prevent the government from going in for major interest rate cuts. Lower interest rates might lead to a lower number of people entering the scheme. This might lead to a situation wherein the servicing of existing deposits becomes difficult.
And the Ponzi scheme might go bust when the amount of money leaving the scheme becomes greater than money entering the scheme. The government would not like that to happen hence the interest rate paid on small saving schemes is higher than other similar investments in the market.
Pension funds of Indian banks
Indian banks (other than the State Bank of India) started pension schemes in the nineties. Pension plans are 'defined benefit plans.' The retiree is guaranteed a 'regular fixed income' (which is a certain percentage of the last drawn pay. The pension does not depend on the amount of money that is invested in the pension scheme before retirement).
The pension schemes of public sector banks (other than SBI) in India are under-funded to the tune of nearly Rs 12,000 crore (Rs 120 billion).
A pension plan is fully funded when it has enough money to finance the pensions of those who have retired and also the pension that has accrued. (The accrued pension is calculated on the basis of certain assumptions).
The under-funding of pension funds has not led to a situation wherein banks are not able to meet pension payments of current retirees. But nearly 70 per cent of the funds of these pension schemes go into paying pensions for people who have already retired.
This puts the people who would retire in the years to come at a great danger because their pensions would have to be financed from fresh inflows into the current income. (As is the case with Indian Railways Pension fund, which is discussed next).
There is a great danger that the pension funds might degenerate into Ponzi schemes.
Fourteen banks were nationalised in 1969 and six more in 1980. After the first phase of nationalisation, the banks went on a recruiting spree. This carried on for the next two decades.
A lot of these employees who were recruited after the nationalisation process have retired or are close to retiring. More and more bank employees will retire in the years to come. With the pension funds being under-funded, their pensions will have to be met from current income.
This would mean an added expense and would lead to the profits of these banks coming down. Some of these banks are already listed and some of them plan to get listed (in order to meet the capital recruitments as per the Basel-II norms). Falling profits could hit their stock prices badly.
The Indian Railways Pension Fund
The Indian Railways launched a non-contributory, defined benefit (DB) pension plan for its retirees in 1957. The scheme paid pension to the retirees out of the current year's general revenue.
Essentially inflows into the current income of Indian Railways were being used to pay out the pension benefits, making it resemble a Ponzi scheme. Realizing this in 1964, a pension fund was established.
Indian Railways had to make contributions to this fund every year to fund its accrued pension liabilities. IR did not fund its pension obligations on an ongoing basis and kept servicing its pension liabilities out of current income. So fresh inflows are being used to service pension liabilities.
As Indian Railway has promised its employees to pay their pensions after retirement the entire risk of the pension fund being under funded lies with it. This is threatening the entire financial structure of Indian Railways.
The Government of India has been running a very high fiscal deficit over the last one decade. The combined fiscal deficit of the Centre and the states stands as high as 10 per cent of the gross domestic product. The government finances this excess expenditure over revenue through borrowing.
Conventional wisdom tells us that money that is borrowed needs to be invested in areas where in can get a return higher than the interest to be paid on debt.
But the government cannot always work with the profit motive in mind. The government does not earn enough money to pay back the interest on its debt.
So what does it do? It takes on more debt to repay its earlier debt and also to pay interest on its existing loans. A perfect Ponzi scheme!
Every time a Ponzi scheme collapses, the confidence of the investor in the financial system goes down. Investors become reluctant to part with their money. This, in turn, hampers the ability of the capitalist system to raise capital.
Since most of these government schemes are long term, immediate threat is not apparent. Besides, the government can source capital to arrange a bailout. Despite that, the presence of these Ponzi schemes indicates the ill health of the financial system. This also highlights the fact that the money collected is not being invested properly.
Most of the government-run pension and provident funds do not even have a treasury department to take care of the money that is being collected from the citizens of this country.
Since most of these schemes are either statutory or have tax benefits associated with them, they continue to be very popular. Investors, however, need to be careful and not put all their eggs in one basket.
Vivek Kaul is Research Scholar, ICFAI University; and Hasan Ahmed is Senior Executive, HRD, Gujarat Cooperative Milk Marketing Federation (AMUL).ALSO READ: You may have to pay more for patented drugs