Thursday, November 03, 2011

Exploring Chit Funds

This Diwali, my father in law finally decided to take me seriously.  He wanted to discuss a new business he was planning on investing into - a chit fund as a major promoter of the business. I was a bit surprised at the nature of business, because for me chit funds were what women did at kitty parties. It was the investment method of choice for hundreds of Gulf widows in Kerala. They joined 'chitties' with small amounts saved from the money sent to them by their expat husbands from the deserts of Arabia and bought flashy appliances and gold with the money they saved or paid dowry for their daughters.

In her working paper for Institute for Financial Management and Research, Small Enterprise Finance Centre, Preeti Rao classifies Chit funds as the Indian equivalent of the Rotating Savings and Credit Associations
(ROSCA) that are famous throughout the world. ROSCAs are a means to ’save and borrow’ at the same time. It is considered one of the best instruments to cater to the needs of the poor.

According to her paper the concept of chit funds originated more than 1000 years ago.2 Initially it was in the
form of an informal association of traders and households within communities, wherein the members contributed some money in return for an accumulated sum at the end of the tenure. Participation in chit funds were mainly for the purpose of purchasing some property or, in other words, for ’consumption’ purposes.

She explains that a chit scheme generally has a predetermined value and duration. Each scheme admits a particular number of members (generally equal to the duration of the scheme), who contribute a certain sum of money every month (or everyday) to the ’pot’. The ’pot’ is then auctioned out every month. The highest bidder (also known as the prized subscriber) wins the ’pot’ for that month. The bid amount is also called the ’discount’ and the prized subscriber wins the sum of money equal to the chit value less the discount. The discount money is then distributed among the rest of the members (or the non-prized subscribers)
as ’dividend’ and in the subsequent month, the required contribution is brought down by the amount of dividend.

To illustrate the above, let us take the example of a chit scheme with the following characteristics. Chit Value = Rs.500000, Duration = 50 months and Members = 50. The contribution in this case would be initially Rs.10000 per month per member. In the first month, the collection would, therefore, be Rs.10000 multiplied by the number of members i.e. Rs.500000. This amount is called the ’pot’ which is auctioned out at the end of the month. Now let us assume that the highest bid in the first month auction is Rs.100000. This is called the ’discount’. The highest bidder now gets the amount equal to the chit value, Rs.500000, less the discount, Rs.100000, i.e. Rs.400000. The discount amount of Rs.100000 is then divided among the other 49 members equally (the dividend for the 49 members work out to roughly Rs.2040 each). For the subsequent month, therefore, the contribution of these members reduces by the amount of dividend (i.e. the contribution in the second month for the 49 members would be Rs.10000 less Rs.2040 which is equal to Rs.7960). This process gets repeated for all months till the end of the scheme.

My father in law thinks that there is a need for a Chit Fund that caters to the huge very small enterprise sector. MIDC Bhosari is home to almost 100000 plus such fabrication and job work establishments which do not qualify for institutionalised support in the form of loans or line of credit. My maternal uncle is one such fabrication shop owner who over the last 25 years has done well to establish a series of 'factories' all over Pune district. He says when he started, it was difficult to get a loan and the only way to buy equipment was to join a chit fund and bid for the 'pot' right at the begining and repay it over a 12 to 24 month period. To date there are small operators who run unauthorised chit funds. Many are fly by night operators and people get conned into losing small sums that they invest.

The reputation of the chit fund depends on the ability of the person managing the business. While there have been large organisations like Peerless and Sahara in India which have run chit funds and have used the money to spin themselves into multi crore companies, it is the small fly by night operators that have given the business a bad name. The personal integrity of the team and the adherence to systems and timely audits are the key to the success. The new chit fund that is being proposed is supposed to be a private limited company with some big names in Pune as promoters, a good audit firm on board and a desire to follow the rules.

The economics of the business are sound. When they reach 10000 members who participate with an average of Rs 2000 per month they expect to start making money. They plan to expand into other industrial cities which have similar needs.

The second market they plan to target are the women who want to save but do not get good return due to low rates on FDs and do not have the knowledge to explore other options. These women use the chit fund route to fund their immediate needs and sometimes to support small home based businesses to suppliment their home expenses. A market that RangDe has been successful with.

I was expected to look at the business plan and suggest changes and whether something like this can attract an investor. My honest answer was that I am not sure. I see not differentiator to allow the business to scale up. The business is very locality based and cannot reach a large audience without legs on the ground. To scale up the investments are very large. Having said as much, it potential is mind boggling. Back of the envelop calculations say that they can be profitable within a year of operation in Pune itself. If they use technology - internet and mobile to make payments easy, the target market can move from the lower end to bigger ticket customers. The entire middle east is open to a tech savvy option where the tech savvy Indian can log into and invest without having to involve money transfer and impossible to verify operators.

A few friends on Twitter called Chit Funds a form of Ponzi scheme. My take is that any money related scheme can turn into a Ponzi scheme, there are enough respectable businesses that one reads of who inflate valuations for an IPO and then go bust within few months of the gulliable retail customer investing their saving in the scrips. Fiscal discipline and the ability to play a neutral and honest role in the management team is important. But then this applies to any business.

I will update this blogpost as the business matures, not because I have anything to gain from this venture but because I feel that ventures of this kind if run well have the ability to bring about crucial social change by making capital available when one needs it.

1 comment:

Skumar said...

We Care India is another platform ( similar to Rangde) that recently launched and operates at grassroots bypassing a field partners. Check it out at also their blog at