The Rough Market: A Nice Place to Commit Suicide
(March 17, '11, 11:39 Chaim Evan Zohar)
(IDEX Online) - “Despite the DTC’s price increase, the market remains in full speculative overdrive,” remarked a leading DTC broker, who thoughtfully added, “neither bankers nor experienced traders have a clear answer to the situation.” The broker further observed, “It is frightening to see that some traders pay up to 45 percent more for certain items compared to one month ago.” Whatever the price increase (10 percent), DTC boxes continue to trade at two-digit premiums, with many in the plus-20 percent range. And, at any given time, mixed rejection goods secure a 25 percent premium on whatever the box price may be.
Who are we kidding when we say “we don’t understand” what causes this? We all, more or less, do understand the issue – but, just like having a bunch of mistresses, this is not a subject we like to talk about too loudly. Read my lips: the answer is India. The single-most serious distortion the industry faces in the current market structure is the abundantly available financing in India and the ability to make more money from financial manipulations than from diamonds.
In some instances in India, diamonds have just become a means to make money – without a need for the diamonds to reach any ultimate consumer. That isn’t the main purpose of being in this business – at least it’s not for some, I should carefully qualify lest I do damage to good and deserving diamond companies.
The ‘Trouble’ with the Banking System
By law, all Indian (mostly state-owned) banks must allocate a part of their lending portfolio – some 15 percent – to the financing of exports. Any exports. Moreover, by instructions of the central bank, this financing must take place at concessionary (subsidized) terms; there is a significant differential between the borrowing cost of domestic, private and corporate players and those of exporters, including diamond exporters.
In addition, diamond exports are, from a banking perspective, simply straightforward. Compared to exports of textiles or furniture, there is no need for extensive third party confirmed letters of credit, export documentation, document inspection, bank guarantees from overseas customers, etc. Other exports require a small bank to have a huge export department. In the case of diamonds, a few people will do.
Financing diamond exports is a fantastic and easy way for banks to meet the government targets. The risks are near to zero, and the bank meets governmental export-financing requirements. Not making the targets, by the way, will force the bank to invest its money in low-yield government bonds – so there is a penalty for not meeting export-financing targets. It is, therefore, why Indian banks love to finance the diamond industry.
In early 2011, there were over 80 banks in India engaged in diamond-industry financing. Because, historically, the default by diamantaires requiring write-offs in India is near to zero, banks there have become extremely lenient in extending money.
The ‘Trouble’ with Diamond Manufacturing
Faced with protracted low manufacturing profitability, Indian diamantaires are seeking other ways to make money – again, not all diamantaires or even most of them. There are thousands of excellent manufacturers that create diamonds just for jewelry. But one needs only a handful of manipulators to create massive market distortions.
The access to subsidized finance has enabled the Indian diamond industry to develop substantial revenues by using diamond exports simply to secure enormous amounts of financing well and above the diamond-industry needs. The money obtained in this manner is then diverted to other investments in stock markets or currency trading or, more often, used as granting loans to the non-diamond borrowers in India. The differential between the cost of formal borrowing and the interest rate received on investing money in the “secondary” (gray or informal) financial market can easily exceed 10 percent at any given time.
By simply borrowing an aggregate of $100 million, an Indian diamantaire can earn $10 million without actually having to spend a single penny out of his pocket. However, he needs some diamonds – and he needs to show rough diamond imports to justify the volumes of polished carried in his books.
That, dear DTC broker and others, is where the problem starts.
Manipulations Trigger Competition Distortions
In a recent symposium in India, with the participation of industry and leading bankers, yours truly, acting as conference moderator, publicly raised the issue of “round tripping,” which is the local term for the practice in which the very same parcel of diamonds may simultaneously be financed four or five times. Therefore, $10 million in polished exports can generate bank financing of some $50 million anywhere between 90-120 days, or sometimes more.
This round tripping is not a secret; the government is acutely aware of it, and it can easily be seen by looking at the gross and net exports of the Indian diamond industry. In terms of volume, India polishes 11 out of 12 diamonds in the world (or maybe 14 out of 15). In terms of value, about 60-70 percent of diamonds worldwide are polished in India.
However, if one looks at the Indian polished exports, one will see that gross exports are equal to 1.5 times the world polished production, more than two times India’s own polished production and equal to almost three times India’s net exports.
Please read this last sentence two or three times – just to let it sink in.
This round tripping was exacerbated after May 2007 when duties on polished imports were removed. This eliminated the need to smuggle in the polished that had to be submitted again to the bank for further export.
This gets us to two points:
(1) There is a huge sector in the diamond industry that can make money from diamonds from a demand
that is totally unrelated to the final consumer demand. This presents a major distortion in the structure of the diamond industry.
Rough price is affected, for example, in periods when Indian diamantaires need to “close their books” and show greater amounts of rough. Looking at the Kimberley Process data, one can see that, measured in carats, India normally imports double the amount of cuttable rough produced in the world in any given year – and it does so year after year.
Consequently, the net affect for the rough producer is that there is a significant demand for rough which is not related to actual consumer demand and which is being used for extremely profitable enterprises.
(2) This also means that, very often, Indian manufacturers or rough importers are willing to overpay for the rough as the value of the resultant polished has become hardly relevant. When one sees that the price of rough quite “overshoots” the economic price, this is most often the explanation.
So why not simply “round trip” rough as well? First of all, that IS being done. But it is more complicated. The Indian government knows very well that the resultant polished out of rough is 20-23 percent. So take a theoretical diamantaire who has one million carats of rough and from this he has polished 200,000 carats. By round tripping, he shows 600,000 carats of polished in his books – and this means that government expects to see evidence of 3 million carats of rough imports.
Where does he get these extra rough diamonds? Boxes of mixed rejection goods are a good way to start. If the producers would take these goods off the market, one might see even steeper premiums on other goods!
Demand to Meet Excess Cutting Capacity
This represents, of course, only one market-distorting factor. Indians also have a genuine need for rough to keep factories employed. When in 2008 and 2009 supplies of rough to the market were reduced by some 50 percent, this literally translated into 50 percent less employment in the Indian diamond sector. Between 300,000-450,000 workers were made redundant and even more were put on part-time basis. When the market turned around, many of the fired workers did not come back.
An Indian manufacturer will always do his utmost to keep his factory operations fully operational and his workers fully employed. Even in times of softened demand for polished, a manufacturer will not reduce capacity and will continue to secure the rough and prefer to sit on polished stocks. It should not be forgotten that the average stone size of the Indian production is around 0.02 carats (2 pointers), and in the manufacturing of those stones, labor costs exceed the diamond-material costs.
The industry doesn’t want to send these workers home again. Thus, there is over-production of polished and a shortage of rough for manufacturing – and for the round tripping. Things may calm down a bit when India’s next fiscal year starts on April 1.
What can we do? Not much. Just keep in mind – the current rough market really belongs to the Indians. If you are not one of them – getting into this market may be akin to committing suicide. Perhaps sitting back, at least for a while, may not hurt.
India is destroying the Diamond business with its corrupt practices.
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