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'Majdhaar mein naiyya dole, to manjhi paar lagaye
Manjhi jo naaw duboye, usey kaun bachaye?'
(Couplet from the song Chingari koi bhadke, written by Anand Bakshi for the movie Amar Prem)
The Ponzi scheme
In a Ponzi scheme an illusion of a successful business is created by using the money brought in by the new investors to pay off the old investors.
Essentially, the capital of the scheme is used to pay the interest promised to the investors.
This process of rotating money to hoodwink investors has been used fairly successfully over the years. If one may borrow a French phrase plus ca change, plus c'est la meme chose (the more things change the more they remain the same). The details might change but the structure abides.
Since then many such schemes have come up in India and overseas that have taken the investors for a ride.
In the Indian context some of the famous Ponzi schemes were Anubhav Plantations scam, chit fund scams, Ashok Sheragar schemes in Mumbai, non-banking finance company scams, etc. The intention of these schemes was to defraud investors, i.e. take their money and run.
The government
Ponzi schemes are not always run with the intention of carrying out a fraud. At times very good investment schemes degenerate into Ponzi schemes. Institutions of the Government of India have run few of the biggest Ponzi schemes in the past and they continue to do so currently.
Unit Trust of India's flagship scheme, US-64, degenerated into a Ponzi scheme. The small saving schemes, the PPF, the Indian Railways pension fund, etc resemble Ponzi schemes, the way they are run.
The government does not seem to have learned from its past mistakes and continues to support more Ponzi schemes, the biggest of which is the subject of this article: the Employees Provident Fund.
The Employees Provident Fund
On February 2, 2005, the central government increased the interest rate paid on the investment into the EPF from 8.5 per cent to 9.5 per cent for the year 2004-05. As has been the case in a whole lot of other issues, the Left parties seem to have influenced this decision of the government as well.
The same day the foreign direct investment limit in telecom too was raised to 74 per cent. It is being seen as a compromise with the Left. Give and take seems to be the order of the day.
So what is the problem with this step? For that we will have take a look into the way EPF operates.
The EPF scheme was started in the year 1952. It was made mandatory for private and public enterprises in 177 specified sectors (excluding Jammu and Kashmir) that employed more than 20 people to participate in the scheme.
EPF is a defined contribution scheme. Under a defined contribution scheme, workers build up their retirement accounts and this funds their retirement.
At present the EPF has investments of Rs 102,747 crore (Rs 1,027.47 billion). At an interest rate of 9.5 per cent, the EPF would need to generate Rs 9,761 crore (Rs 97.61 billion) to meet its obligation.
Of the total investments, around 79 per cent are parked in the special deposit scheme (SDS) of the government of India, which pays an interest of 8 per cent. Since April 1997 new subscriptions to the EPF cannot be invested into the SDS although interest earned from SDS can be reinvested back into it. SDS generates a return of Rs 6,494 crore (Rs 64.94 billion) per annum. This means that the remaining 21 per cent of the investments have to generate Rs 3,267 crore (Rs 32.67 billion), which in turn implies a return on investment of 15.14 per cent.
The regulations governing EPF as they are at present in effect imply that 90 per cent of the total funds of EPF are to be invested in government securities. A maximum of 10 per cent is allowed to be invested in corporate bonds, although the actual investment in this asset class is much less.
Further, EPF as of now is not allowed to invest in the equity market. All this makes it next to impossible to generate a return on investment of over 15 per cent on the EPF funds which are not invested in the SDS.
EPF: The Ponzi scheme
Since EPF investments will not be able to generate a return on investment of 9.5 per cent this shall leave a gap on the books of EPF, i.e. returns EPF earns on its investments will be less than the interest that accumulates.
Media reports suggest, this gap will be around Rs 930 crore (Rs 9.30 billion). The finance ministry, it seems, is unwilling to fill in this gap.
The Employees Provident Fund Organization, which manages EPF, plans to fill this gap through the suspense account and recoveries from defaulters. Suspense account comprises those funds that have not been claimed by the subscribers and are unlikely to be claimed in the future.
So the EPF will effectively be using its capital to service returns that fall due, which makes it nothing but a Ponzi scheme.
Such reserves can be used to fulfill the deficit in the present year but the question still remains: what happens in the years to come if the return EPF earns is less than the interest it accumulates and if the government refuses to provide subsidies for the same? The EPFO will then have to use EPF's capital to service its returns.
In fact, EPF was being run as a Ponzi scheme even before this hike in interest rate, though the gap then was a little over Rs 200 crore (Rs 2 billion). So by agreeing to the demand of the Left parties and increasing the interest rate, the government has increased the Ponzi nature of the scheme.
The funds that are not invested in SDS will keep increasing over time as the new subscriptions to the EPF cannot be invested in SDS. These funds, given the present structure of EPF, will be invested into low interest bearing government securities. This shall make it even more difficult to service a return of 9.5 per cent in future, thereby increasing the deficit of the scheme. This might lead to the Ponzi nature of the scheme increasing.
Credit risk
Since most of the investment of the EPF is in government securities, its entire credit risk is concentrated on one entity: the government. History has given us enough evidence that governments the world over are not immune to default on the debt they take.
A good amount of EPF funds have been invested into state government debt as well as debt issued by parastatals. Some of this investment made by the EPF has been downgraded to default status.
While the true magnitude of this problem is not known, it is very clear that EPF with its policy of holding securities till maturity has not marked to market such investments. Once such securities start maturing and state governments start defaulting on them, the troubles of EPF will increase. It might also lead to the Ponzi nature of the scheme increasing with more returns having to be serviced out of capital.
The exempt funds
Employers can seek exemption to manage their own funds (as long as they meet the regulatory requirements) instead of the EPFO doing it or them. The management of such funds is carried out under the overall pattern decided by the EPFO.
Of the 344,000 firms coming under the EPF Act 1952, 2,564 firms are exempt to manage their own funds. Even though the number of such firms is very small they account for nearly one third of all contributions under the EPF.
The 9.5 per cent rate of interest would be difficult for the expect funds to meet given the low interest rate scenario that prevails. Some of the exempt funds may decide to hand over their funds to the EPFO.
With that the fiduciary responsibility will be no longer theirs and the corporations won't have to chip in to ensure that their exempted funds do not face a deficit.
Exempt funds which have come up in the recent years would have more problems meeting the 9.5 per cent rate of return given the fact that they would not have high yielding securities in their portfolios as interest rates have steadily falling in the last few years.
In closing
The fundamental principle of investment theory is: the return on an investment is a direct function of the risk involved. The EPF by investing most of its funds in government securities can only generate a certain amount of return.
But promising its investors an interest greater than the return it is able to generate has led to a situation where the scheme has degenerated into a Ponzi scheme.
EPFO, an organization with nearly 20,000 employees, does not have a treasury department. This obviously does not help. The Union labour minister presides over its 42-member board of trustees and they decide as to where to invest.
EPF needs to hold securities till maturity. So, in an environment where the bond yields were falling, EPF cannot sell its treasure trove of governments securities to make good profits and thus increase its return on investment.
Furthermore, little research that has happened in this area in an Indian context seems to suggest that the EPF would have gained substantially if even a small fraction of EPF contributions had been invested in the domestic stock market.
The increase in interest rate might lead to demands for increase in interest rates on small saving schemes and other provident funds like the Coal Mine Provident Fund. This will lead to an increase in problems for the cash-strapped government.
It is difficult to imagine a scheme like EPF going bust. There are three reasons for the same:
a) It is highly unlikely that there will be a run on the scheme with all the investors demanding their money back simultaneously. Although there are certain restrictions, the regulations of the scheme do allow withdrawals to be made before the employees retire.
b) The fact that it is mandatory for establishments with more than 20 employees in many sectors to participate in this scheme means that there is very little danger of money not coming into the scheme.
A Ponzi scheme usually collapses when the investors stop investing in it. This leads to a situation where money leaving the scheme becomes greater than the money entering it and the scheme collapses. Also, EPF being a provident fund the return on the investment in EPF keeps accumulating and can be withdrawn only on retirement or in certain special cases.
So the fact that EPFO does not have to service returns at the end of every period also helps. This helps EPF to keep running.
c) No government can afford to allow this to happen given the fact that a large number of investors are involved. If it does, it will be committing political hara-kiri. As happened in the case of UTI, the assets of the state will be utilised to organise for a bailout.
Such a bailout will amount to public money being used to bail out the participants of the scheme. So the government will have to rob Peter, the non-participant, to pay Paul, the participant.
In the end what is most surprising is the fact that Dr Manmohan Singh, who after taking over as the prime minister had made all the right noises about the increase in the EPF rate leading to a UTI kind of situation, has now bowed to the pressure created by the Left parties.
Bad politics has once again triumphed over good economics.
DON'T MISS: Why EPF, PPF are Ponzi schemes!
The author is Research Scholar, ICFAI University.