Strength in numbers: how chit funds help the impoverished
When C.Devaraj was approached by the family of a potential suitor for his 18-year-old daughter, he was deliriously happy. And then reality sank in. In order to pay for the wedding, the tailor from the southern Indian state of Tamil Nadu would have to raise Rs60,000 (Dh4,724) in cash in less than three months, which was close to impossible on his monthly salary of Rs8,000. He application for a bank loan was rejected.
When he announced the news of his daughter's engagement to the relatives, and shared his financial anxieties, his elder sister, V. Adilakshmi, offered him a solution."Join my chit," she said, referring to a chit fund she was about to manage. Chit funds are the Indian equivalent of the Rotating Savings and Credit Associations (ROSCA), which are popular in many countries such as Cambodia, Korea and Indonesia. Chits are an important financial tool, providing access to finance for both small and medium enterprises and individuals with pressing cash requirements.
Smaller chit schemes, such as the one managed by Mrs Adilakshmi, operate on an informal level without regulation. Instead, they are governed strictly by trust and intense screening of the participants. A chit scheme typically has a predetermined value and duration. Each scheme is open to a fixed number of members, which is equal to the duration of the scheme in months. For example, 12 members would take part in a 12-month chit fund.
The members contribute the predetermined amount of money each month to the scheme, which is then auctioned out. Every month, members will assemble at the chit manager's house to make bids. The highest bidder, who calls out what is called the "discount", wins all of the contributions made that month, or the "prize money", which is equal to the chit value minus the "discount". After deducting the manager's commission, usually around 5 per cent, the "discount" money is then distributed among the other participants in the scheme equally as a "dividend".
Once a member has won the "prize money", he or she must continue making payments each month, but is no longer entitled to bid at auction throughout the duration of the scheme. In the following month, the contribution for all members is subtracted by the "dividend" each member received. To provide an example, Mr Devaraj agreed to participate in his sister's chit scheme. With 20 members in total, each person agreed to contribute Rs5,000 over the course of 20 months. Therefore, the total value of the chit up for auction each month was Rs100,000.
When it came time to bid, the minumum "discount" was set at Rs10,000, which meant that in any given month, the maximum amount a member could collect would be Rs90,000 (Rs100,000 prize money minus the minimum bid of Rs10,000). As is often the custom, the first month's chit is automatically allotted to the manager of the scheme - in this case, Mrs Adilakshmi - as they tend to bear an enormous risk should any of the other members default on payments. She bids Rs10,000, the minimum amount, and collects Rs90,000 for herself.
In the second month's chit, Mr Devaraj bids Rs30,000. Luckily for him, the other members' bids were lower than his. Consequently, he succeeded in securing around Rs70,000 after investing only Rs5,000 the first month and Rs4,474 in the second month. His payment was less in the second time around because it's always subtracted by the dividend each member receives in the previous month (which in this case was Rs526, or Rs10,000 divided between the remaining 19 members).
With the cash in hand, he celebrated his daughter's wedding and continued to contribute every month to his sister's chit scheme. Overall, it served as a timely lump of cash without having to apply for a loan and take on the burdens of interest and debt. He will also benefit from dividends throughout the life of the chit. "The history of chit funds can be traced back to more than 2,000 years ago," says R. Kannan, a senior director at Shriram Chits, one of India's largest chit fund entities, with an annual auction turnover of about US$715 million (Dh2.6 billion).
In ancient times, it was the village chieftain's responsibility to collect grain from the villagers and store it for contingencies. The excess grain would be redistributed among the households on an annual or biannual basis. Should a family require financing for other expenses, he would release the grain depending on the capacity and capability of the borrower to repay the grain. In modern times, this system was altered and extended to money and brought under regulation by the Tamil Nadu Chit Fund Act (1962) followed by a central government Chit Fund Act (1982).
"India in the 1970s and 1980s was a different place. Banks had restrictions on lending to the middle class and the government's programmes were primarily addressing the poor and industries. The middle class needed money and chit funds emerged as an instrument that encouraged saving but also allowed borrowing, without interest," Mr Kannan says. A large chit operator such as Shriram Chits, for example, has a community of 2,200,000 subscribers, who participate in various chit schemes operating in the states of Andhra Pradesh, Karnataka, Maharashtra, Tamil Nadu and Pondicherry.
Although the company does not screen members, newer participants are not allowed to participate in the auction for the first few months of the scheme and may only contribute to the "prize money" during that period. Company-run chit schemes may also demand collateral from members prior to their participation in the auction. Home-run and unregistered operators such as Mrs Adilakshmi's, however, subject their schemes' participants to intense scrutiny and background checks.
"My criteria is very simple," she says holding out three fingers. "Participants must live in their own homes. If they're renting they could run away and I would never know where to look for them. They must not have any debts. They must have a regular monthly income." @Email:firstname.lastname@example.org
Updated: August 28, 2010 04:00 AM