Albania's Pyramid Schemes - Case Study Example

Albania’s Pyramid Schemes Introduction In 1940s Albania had a predominantly agricultural economy, and depended ona classic Stalinist economic model characterized by central planning, and bureaucratic decision-making processes (Kindleberger 54). This model prevailed until the beginning of the 1990s, when the government initiated economic reforms which promoted private ownership (Davies 78). The private sector contributed about two third of the GDP, and the rising remittances from the Albanians working Greece and Italy increase the disposable incomes. The improved economic environment increased consumer imports, and investments in the emerging pyramid schemes. Lack of proper financial institution and securities markets encouraged the Albanians to look for alternative investment opportunities such as the pyramid schemes. This paper examines the effects of the pyramid scheme on the local economy. 2. Background As suggested by Dirk pyramid schemes operate on a simple principle whereby, money paid by the later investors is used pay artificially high returns to earlier investors (78). At first, early investors are promised high returns to woo potential investors. As the word spreads, many people are pulled into the scheme to benefit from the huge capital gains. As Jarvis observes during the early phases, the whole process seems to work, but with time the interest and principal owed to the old investors exceed the money that the scheme has (5). As a result, investors are forced to cut short the payments and investors start panicking. Some of the players that were involved in the pyramid scheme include VEFA which was formed in 1992 by Vehbi Alimuca, and took in at least $700 million in deposits. The institution started as a trading company and is accused of promising customers unsupportable rates. The second major player is Xhafferi which was formed by Rrapush Xhafferi and at the time of its collapse it had taken $250 in deposits. Another key player in the pyramid scheme was Gjallica which was formed in 1991 and took in an estimated $850 million in deposits. Sude on the other hand, offered lottery services but thereafter started taking deposits from the customers. At the time of its collapse, the company had $90 million in liabilities and no assets. Just like Sude, Populli offered to pay its customers two times principal invested after 3 months. The company worked closely with the Albanian opposition parties, and at the time of its collapse its liabilities were over $150 million. 3. Events leading to the crisis As Chris Jarvis, an IMF economist observes in the article titled, the rise and the fall of pyramid schemes Albania, the origin of the pyramid schemes can be traced to the decline of the smuggling market. According to Jarvis the smuggling of oil products through Albania ended with the suspension of the UN sanctions against Yugoslavia (10). As a result, the pyramid period schemes were forced to look for alternatives sources of income. One of the viable ways at the time was to increase the interests so as to attract capital from potential investors. Within a short time the deposit-taking market grew tremendously, and by the mid-1996, the deposit-taking companies were offering interest rates as high as 19%. In the first few months, the companies had attracted two million depositors, and the number continued to grow in the second half of 1996. The players in the informal sector competed by offering attractive rates and just to illustrate, in the September 1996 Populli offered a monthly interest are of 30% which Xhafferi countered with a 44% rate while Sude offered to double the principal in two months. To capitalize on these opportunities some of the investors sold their property while other sold their animals, and then put the proceeds in the pyramid schemes. Worried about the integrity of the schemes, the Governor of Bank of Albania issued the first warning, and then followed by the Minister of Finance. The government formed a committee to investigate the schemes but unfortunately it never delivered. All long, other institutions including the IMF continued to warn the government about the toxic nature of the pyramid schemes, but government chose to disregard their advice. The effect of allowing unlicensed companies to engage in deposit-taking companies, started being experienced at the end of the 1996, and subsequently, the World Bank and the Bank of Albania issued a public warning which went unheeded until in November when Sude collapsed. 4. Economic and political reasons behind the scheme 4.1 Political climate As suggested by Christopher Jarvis in the book titled, the rise and fall of the pyramid schemes in Albania, between 1945 and 1985, Albania political leadership was wanting, under the rigid dictatorship of Enver Honxha. At the time, the government’s political policy was based on the principles of central planning, elimination of private ownership and insistence on national-self reliance. As a result of these policies, the Albania’s economy was isolated and its populace were impoverished. However, in the early 1990s, the economy started to rise, and by 1995 the GDP had grown by 10%, while inflation and external imbalances had greatly reduced. The transformation of the Albanian economy spurred consumerism while industrial output increased significantly. By 1995, the Albania’s economy had exceeded all the targets set by the International Monetary fund, and excited about this splendid performance, the investors took up business opportunities in the textile, oil and soft-drink industries (Blejer 31). These gains were later lost, in the run-up to the 1996 elections due to poor political leadership. Some of the decisions that negatively impacted on the country’s microeconomic performance include the elimination of the VAT and the unrealistic promises by the political aspirants. After the elections which were won by the Democratic Party, the political authority made weak decisions and the leaders were unwilling to make critical decisions such as streamlining the banking sector. Eventually, weak political leadership gave way for the banking industry to engage in the pyramid schemes. 4.2 The problems in the financial sector In the run-up to the crisis, Bezemer observes that the formal financial system was inadequate (18). The banking sector was dominated by the three state banks and private banks found it hard to penetrate the industry. Due to the monopoly that the state banks enjoyed, the quality of services rendered to the Albanians was poor and just to illustrate, customers had to wait for more than 15 days to complete inter-bank transactions. With time, the general distrust for banks increased, with the customers holding a high proportion of their financial assets in cash while others invested in alternative areas. At the time, banking institutions were also faced with the bad loan problem, and to address this situation the Bank of Albania imposed bank-to-bank ceilings. This intervention although appropriate, made it difficult for the private investors to access credit facilities, forcing them to turn to the informal credit market. Indeed, according to a survey conducted in 1996, 36% of the investors relied on the informal market. The growth of the informal market in Albania was tolerated by the authorities, and with time these illegal banking institutions became the best avenues for savings in the country. With little supervision from the government, companies in the informal credit market stopped lending funds, instead preferring to invest the depositors’ funds in productive investments and to some extent criminal activities. 4.3 Weak legal and government framework In the run-up to the crisis, companies involved in the informal market were not adequately supervised not did they pay corporate tax as required by law. In addition, the banking institutions in the informal market operated under the civil code, and failed to comply with the Law on the Banking System. The reluctance by these entities to comply with the applicable laws was helped in part by the laxity of the government institutions. Just to illustrate, the Central Bank, the Ministry of Justice, the Bank of Albania and the Chief Prosecutor, failed to close the borrowing companies as provided for in the Law of Banking System. As Blumi reports members of the government also colluded with the borrowing companies for financial gains (2). Political parties and senior government official benefitted from campaign contributions from companies such as VEFA. 5. Effects of the government’s actions on the economy The government took both short-term and long-term measures which will be discussed later in the paper. However, some of the aspects of the government’s decisions need to be discussed in this section. One of such decision is the reluctance by the Albanian government to bail out the pyramid scheme depositors. This decision was viable because at the time, the government was facing budgetary constraints and compensating the depositors would have resulted to major fiscal costs. In addition, to close the budget deficit caused by the unexpected loss of revenue, the government reduced the public sector wages in 1997. Again this measure allowed the government to deal with the high levels of inflation that were being experienced in the country. 6. Short-term and long-term effects of the pyramid In the article titled, the rise and fall of the pyramid schemes in Albania, Jarvis points out that by 1997 the liabilities incurred by the pyramid schemes accounted for half of the entire GDP (21). In the article, Jarvis also likens the pyramid schemes to the bubble whereby the demand for products and the money supply in the market (21). After the bubble burst, capital inflows and actual and perceived wealth reduced instantly. As result, the demands for goods reduced and this could explain the reason why imports too reduced after the collapse of pyramid schemes. However, as Jarvis admits it was not possible to identify some of the micro-economic effects of the pyramid schemes as most the players deposited the money with state-owned commercial banks (21). In turn, commercial banks invested their money through treasury bills thus allowing the government to close the budgetary deficits. In other words, a significant proportion of the money did not trickle down to the real economy and as such its economic effects were rather limited. Even then, the few short-term effects that were experienced are detailed below. 6.1 Short-term effects 6.2.1 Loss of revenues Some of the government owned businesses such as the posts and tax offices were closed after the crisis. In addition, most of the many industries ceased operating, the effect of which the government revenue collections reduced significantly. 6.2.2 Increase in inflation In the year 1996 the inflation rates increased to 17% while the current account of the balance of payments reduced by 2% of GDP. After the collapse of the pyramid schemes and subsequent eruption of civic disorder the government’s revenue steam was cut short, leading to depreciation of the exchange rate, and increase in the inflation. 6.2 Long term effects According to Humphrey, it is hard to identify the long-term effects of the pyramid schemes, as most of the money did not trickle down to the real economy (56). Humphrey further observes that limited effects of the scheme could be attributed to the resilience of the Albanian economy (80). Even then, a few long-term effects that were experienced are discussed below. 6.2.1 FDI investment Due to poor government regulation, the foreign investors were reluctant to invest in Alabania. Capital inflows reduced as well, as the potential investors were discouraged by the volatile political stability and the inability of the Albanian government to regulate the informal market. 6.2.2 Poverty As a result of the pyramid schemes, thousands of Albanians were left impoverished. Some of the investors had sold their property and put the proceeds in the schemes, and when borrowing companies collapsed they were left with nothing. On the positive side, the agricultural output increased as the discouraged investors, aggressively engaged in farming activities to offset the money lost to the pyramid schemes. 7. Interventions 7.1 Short-term measures The first borrowing company to collapse was Sude, followed by Gjallica, an event that caused huge civil unrest in the Southern City of Vlore. In response to the civil unrest, the government took a number of measures which will be detailed next. Firstly, the government froze the accounts of the borrowing companies, and limited withdrawals to $300,000. This measure was intended to prevent unlicensed companies from withdrawing depositors’ money. This measure helped the government to seize the assets of the companies which were then returned to the depositors. Under the leadership of the Fatos Nano, the chairman of the Socialist Party, the interim government with the cooperation of the internal partners took deliberate measures to improve the economic health of the Albania. In this regard, the international Monetary Fund and the World Bank greatly assisted the government to restore tax collection and restore stability in the Albanian cities. To improve the ailing economy the government also raised the VAT, initiated structural programs and strict monetary controls. According Pettifer and Miranda these measures improved achieved the following results: the output and the value of the local currency increase significantly, inflation reduced by 11% and the budget deficit was brought under control (45). 7.2 Legal framework One of the immediate measures that needed to be performed is the closure of the remaining pyramid schemes. However, this action was impeded by the lack of a proper legal framework, and the reluctance of the politicians to act on the errant entities since they had invested their money in the schemes. Eventually, the law was passed in 1997, and it gave way for the appointment of administrators. The new administrators would be sources from major accounting firms and were given authority to sell the companies’ assets, and seize the assets of the persons associated with the pyramid schemes. The new administrators took up their duties in November 1997, and the delay in their appointment gave the scheme owners an opportunity to reduce the liquid assets. The work of the administrators was hampered by the lack of cooperation from the scheme owners and the employees. There also great rivalry between the administrators and the government officials hence impeding the asset recovery process. 8. Impact of the schemes 8.1 Protests Following the collapse of the pyramid schemes, civilians poured into the streets in what is now referred to as the Albanian anarchy of 1997. The first protests took place on 16th January 1997 followed by another one on 24th January. Protests started from the Southern areas and then spread to the North. With the help of the rebels and the socialist forces, the protesters destroyed government buildings and the process 2,000 people were killed. Eventually, the protests spread to Tirana, forcing the government resign and an interim coalition was appointed. 8.2 Civil wars Following the collapse of the pyramid schemes, looters amassed arms from the government armoires. The citizens took arms for self-defence purposes and as a form of reimbursement from the money lost in the scheme. Yurchak estimates that during the 10 day civil unrest, 3,600 explosives, 650,000 weapons, 1.5 billion ammunitions, 3.5 million grenades and 1 million mines were looted (67). The influx of small arms impacted negatively on the national security as armed robbery and banditry cases increased tremendously. By 1998, the crime rates in Albania were higher that the global average. Some of the weapons that were looted were trafficked to the ethnic Albanian rebel groups, the refugees from Kosovo crisis and Greece. In total, an estimated 200,000 weapons were smuggled into Kosovo, Macedonia and the neighbouring countries. Access of weapons, facilitated the Kosovo Liberation Army to engage in armed conflict. 9. Conclusion The pyramid schemes in Albania occurred at a time when the country’s economy was transitioning from being centrally controlled to a free-market system. The spread of schemes was encouraged by lack of adequate regulatory framework and political will to regulate the activities of the borrowing companies. The pyramid schemes took in a lot of depositors’ money due to lack of proper legal framework and opposition from the outgoing parliamentarians. The presidential decree finally paved way for the appointment of the administrators and subsequent recovery of the illegal assets. Although, the scheme was widespread, its macroeconomic effects were limited and short lived. The civil disorder experienced after the crisis affected government revenue collections and enhance the rebels’ military might. The crisis highlights the importance of regulatory frameworks and stable financial systems to ensure institutions in the banking industry are well supervised. Works cited Bezemer, Dirk. Post-Socialist Financial Fragility: The Case of Albania. Cambridge Journal of Economics 25.1(2009):1–23. Print. Blejer, Mario. Albania: From Isolation toward reform. Washington: International Monetary Fund, 1992. Print. Blumi, Isa. Hoxha’s Class War: The Cultural Revolution and State Reformation, New York: Nova Science, 2000. Print. Davies, Norman. Europe: A History. Oxford: Oxford University Press, 1996. Print. Dirk J. Bezemer. On Eagle’s Wings: The Albanian Economy in Transition. 1961–1971. East European Quarterly 33.3(1999):2. Print. Humphrey, Caroline. The Unmaking of Soviet Life: Everyday Economics after Socialism. Ithaca, NY: Cornell University Press, 2002. Print. Jarvis, Christopher. The Rise and Fall of the Pyramid Schemes in Albania. Washington, DC: IMF, 1999. Print. Kindleberger, Charles. Maniacs, Panics and crowds: A history of Financial Crises. New York: Basic books, 1978. Print. Pettifer, James, and Miranda Vickers. The Pyramid Banking Scheme and the Democratic Party Government. London: Tauris, 2007. Print. Yurchak, Alexei. Entrepreneurial Governmentality in Post-Socialist Russia: A Cultural Investigation of Business Practices. Armonk, NY: M. E. Sharpe, 2002. Print. Read More