Albania’s Pyramid Schemes

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Albania’s Pyramid Schemes

1. Introduction

In 1940s Albania had a predominantly agricultural economy, and depended on a 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.

1. 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.

1. 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.

1. 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.

1. 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 countr.............