Hi, today we're going to be looking at ROSCAs and Chit Funds.
What is a ROSCA, what is a Chit Fund?
A ROSCA is a Rotating Savings and Credit Association
Here's how it works.
We have four people, Aadi, Hansa, Viraj and Prija.
In period one, they each put 10 dollars into a pot,
creating a pot worth 40.
One of them is then randomly chosen to receive the entire pot.
Let's suppose it's Hansa.
In period two, each one again puts ten dollars into the pot.
The pot is again worth 40 dollars.
Hansa, however, is no longer eligible to receive the pot.
So there's a random choice among the remaining three.
Let's suppose Aadi wins the pot.
In the third period we have the same thing.
Each one of them puts in 10 dollars.
One of them is randomly chosen to receive the pot.
And then finally, in the fourth period,
each one of them puts in 10 dollars and the one remaining person,
in this case Prija, receives the pot.
Okay, you might be asking what's the big deal?
Aadi, Hansa, Viraj and Prija each paid 40 dollars in total.
Each received 40 dollars.
What's the advantage?
Well, the advantage here is that with no ROSCA
each person saves 10 dollars per period and spends 40 in period four.
With the ROSCA Hansa receives 40 dollars in period one, three periods earlier.
Aadi receives 40 in period two, two periods earlier.
And Viraj receives 40 in period three, one period earlier.
Prija receives 40 in period four, the same as before.
So three of them are better off in getting the money earlier.
The fourth one is at least as well off as before.
In fact, in expectation, all of them are better off.
So this is a Pareto optimal scheme, to use the language of economics.
At least some people are better and no one is worse off.
Okay, that's a ROSCA.
This is called a random ROSCA.
In a random ROSCA, the person who wins the pot is chosen randomly.
In an auction ROSCA, the partial pot goes to the highest bidder.
Let's show how bidding works.
Bidders are going to bid how much they are willing to pay for the pot.
So suppose the pot is 40.
Aadi bids 5, Hansa bids 9 and Viraj and Prija bid 0.
In this case, Hansa wins the pot.
She receives the 40 dollars minus her 9-dollar bid, or 31 dollars in total.
Hansa's 9-dollar bid is then split equally among the other members,
three dollars, three dollars, three dollars.
A nice thing about the auction ROSCA
is that it allows those who have more urgent needs
to receive the funds earlier than those with less urgent needs.
So again, this is the Pareto optimal improvement to a random ROSCA.
Another interesting thing about these Auction ROSCAs
is that how much people bid,
that implicitly is setting up an interest rate.
It's telling us how much people are willing
to pay to receive the money earlier.
So it's an interest rate.
And how much people are going to bid is going to be dependent therefore
on how good their borrowing opportunities are elsewhere in the economy.
What's the interest rate among moneylenders or among
microcredit organizations, or family and friends, and so forth.
This means that the bidding process is actually quite complicated
because it depends upon the situation elsewhere in the economy.
Also, since some of the bids are going to be returned,
you know, it might be a little bit of an incentive to bid higher
to get the other person to bid higher, so that you get a little bit more.
So, it's a quite complicated auction process.
And comparing theory and practice, it turns out people actually do quite well
at solving these problems.
ROSCAs are very common, both in history and around the world,
Africa, Latin America, Asia.
And in several African countries,
it's been estimated that 50 to 90 percent of the population participates in a ROSCA.
In India, the indigenous term for ROSCA is Chit Funds.
And in addition to informal Chit Funds, there are actually thousands
of regulated commercial chit funds which advertise their services.
In a commercial chit fund, a foreman organizes the fund
and guarantees the pot against a fault in return for a commission.
Often the foreman might get the first pot, for example.
Organized chit funds are more common in urban regions
where people don't know each other as well as in villages.
And the foreman's job is to balance membership between savers and borrowers
and to make sure that no one defaults.
And if someone does default, to make up for the pot.
Some of the regulations require foremen to put up, in advance,
at least one pot to have that in escrow.
In addition, there's a limitation in many states
on how much people are allowed in an auction ROSCA to bid for the pot.
So in effect, this is an usury rate, a limit on the interest rate.
Some of these regulations are probably a good idea.
More recently, there's been more regulation
and this has been pushing people, particularly the poor,
into the informal chit fund area.
There are at least 10 times as many informal chit funds
as there are regulated commercial chit funds.
Both tend to work reasonably well.
Though the informal chit funds are more risky,
particularly if you don't know the other people who are investing.
So why do people invest in ROSCAs?
Well, as the name indicates, it's about savings and credit.
First it's a way of creating discipline to save,
helping to overcome a self-control problem,
having, every month, to put something in the pot helps you to save.
This could also be another control problem.
That is having to put something in the pot every month
means that somebody else can't spend that money.
Perhaps a wife wants to stop a husband from drinking the money away, for example.
Sometimes that does happen.
These savings are then often used to purchase lumpy goods,
perhaps a small business investment,
an investment in a consumer durable like a washing machine,
investment in a marriage or even in jewelry,
especially in India that's quite a common big item to purchase.
The Auction ROSCAs are also used for emergency credit situations.
Sometimes it's hard to distinguish these two uses.
So, in a survey, 72% of chit fund members
said that they were doing this for savings reasons.
That was ex-ante, however.
If you looked among bidders in any given month,
why they were bidding,
'emergency needs' was listed by 56%,
followed by business investment at 30%.
So it's a combination of savings,
having that money also available for an emergency use.
We'll be talking more about finance in future lectures.
It's important to keep in mind that
ROSCAs and chit funds are part and parcel of a large set of ways of getting credit.
Borrowing from family and friends is another,
from micro lenders, from moneylenders,
even from banks.
Microcredit's very important, ROSCAs are very important for balancing
particularly consumers and consumer durables and purchases.
Even more important for a country, however,
is raising lots of money to invest in big business,
to invest in factories and things of that nature,
economies of scope and scale.
That's what we'll be talking more about in future lectures on finance.
Thanks.