Rapaport Magazine

Market Correction

Diamond markets under pressure. Rough prices must go down, polished prices must go up and manufacturers must make money.

By Martin Rapaport
Markets don’t lie but they do correct. Over the long term, free markets are perfect because they equate supply and demand by establishing democratic prices that honestly reflect the relative value of all goods and services in the market. In the short term markets are often imperfect, as they reflect manipulation and abuse by interested parties seeking to gain short-term profits at the expense of long-term sustainability.
   Trading short-term profits for long-term losses is a dangerous game. Going for the easy fast buck in a carpe diem “live for the day” world creates market imbalances. The inevitable correction of these imbalances often takes place at the worst of times, when market forces are negative. Such was the case in the 2008 housing crisis when banks over-extended their credit, resulting in unsustainable housing price increases.
   Obviously, taking short-term gains at the expense of long-term loss is not wise. Whether it’s going to a party instead of studying for a test, eating too much at a fancy dinner and eventually suffering a heart attack or borrowing too much money and then being forced into bankruptcy, the long-term price you pay is not worth the short-term benefit.
   Many firms cannot resist the temptation of immediate economic gratification. Whether it’s taking too much money from the banks, bidding up rough prices to unsustainable levels, increasing revenue at the expense of profits, bribing government officials, selling overgraded diamonds, mixing synthetics into parcels of natural diamonds or simply not paying bills, it’s hard to resist an easy fast buck. The situation has become worse as structural defects in the dynamics of the diamond markets have destroyed the ability of firms to make normal profits. Competition from firms engaging in unsustainable practices has also forced some good firms to make bad decisions just to stay in business.
   For example, if your competitor takes on huge debt so that he can overpay for rough diamonds, what should you do? Must you close your factory or should you also pay too high rough prices in order to stay in business?
   Unfortunately, global diamond markets have been predisposed to making bad short-term/long-term trade-offs. In a nondifferentiated competitive market, legitimate firms have been forced to compete with firms that take shortcuts enabling them to offer lower prices. The net result is that cycles of negative behavior have developed, exposing the trade to significant economic and reputational risk.
   We have now reached the stage where leading diamond manufacturers and dealers have come to the realization that their current business models are unsustainable. In the words of Maxim Shkadov, president of the International Diamond Manufacturers Association (IDMA):“Our sector is going through a severe crisis and suffers significant problems.…There is no profitable income to be made in diamond manufacturing.…The seriousness of the ‘disconnect’ between the producers (miners) and the manufacturers can no longer be ignored.” (See President’s Letter.)
   Shkadov is talking about the unsustainable disparity between high rough and low polished diamond prices. He is protesting the disregard of mining companies to the plight of diamond manufacturers who can no longer make profits.
   From the miner’s perspective, there is no reason not to accept the high prices that diamond manufacturers offer for the rough. What the manufacturers do with the rough and whether or not they make profit is of no concern to the miners.
   Underlying all this is the role of the Indian government and bankers who have enabled the over-financing of the diamond business, resulting in irrationally high rough prices that ensure manufacturing losses.
   The situation in the diamond trade has reached a desperate point where firms have lost confidence in how the market operates. Simply put, good people are working their hearts out and losing money. As losses increase, some are panicking, they do not want to lose their life savings. Many blame De Beers and the other mining companies, others blame Rapaport and RapNet because our price list and trading networks promote transparent competition that makes it hard to raise polished prices. The trade is caught between rough and polished prices. The diamond community is afraid for their future and the leadership does not know what to do.

Understanding the Situation
   While the situation is highly complex, it is understandable and solvable. In fact, the crisis we are currently experiencing is healthy, as it provides an opportunity for the diamond trade to right itself and realign short- and long-term market priorities. If we handle the crisis correctly and make the necessary corrections, then we can transition our trade to higher levels of sustainable profitability with unlimited growth potential for the future.
   It is important to recognize that the crisis is uniting us in the quest for honest, durable solutions. Solutions will not be developed by firms blaming each other but rather by working together in a cooperative manner to create fair diamond markets that serve the mutual benefit of our community.
   Our first step is to gain an understanding of what is really going on. The diamond trade currently faces two very different types of challenges and it is important that we do not confuse them.

   External challenges created by events beyond our control. This includes macroeconomic events that have reduced demand, such as slower growth from China, a weaker euro and ruble and lower oil prices. It also includes a broad range of additional external forces, such as rapidly advancing technology that changes everything — including our ability to synthesize or treat diamonds, how consumers buy diamonds over the internet, changes in fashion, lifestyle and demographics and new competitive luxury products.

   Internal structural challenges. This includes factors that are fundamental to the way the diamond trade operates. For example, bank debt, inventory levels, production volume, costs, labor, liquidity, diamond prices, marketing, profits and a host of other factors determine how we perform and interact within the diamond trade.
   While the external challenges we face may appear frightening at times, they are not a real threat to our existence. As any other industry does, we have the ability and responsibility to change and adapt to the world around us. Changing global economics, demand scenarios and distribution systems are nothing new. One year China is weak, the next it is strong, so what? External changes are no big deal. We can handle them.
   The real problem is that the way the internal structure of our industry operates is unsustainable. We have created a self-perpetuating, highly complex interactive environment that forces market participants to act irrationally and in ways that destroy their ability to make profit.
A good way to understand the situation is to follow the money. Here is a simplified storyline.

   Banks lend too much money to diamond manufacturers and rough dealers. In some instances, banks lend 100 percent of the cost of rough. So buying rough and reselling it is a way to create cash.

   Excess money supply causes rough prices to be higher than the resultant polished. Rough costs more than the polished is worth. Manufacturers consistently lose money.

   Manufacturers bleed money out of the system, using transfer pricing scenarios to store some $13 billion of “extra money” in offshore tax-free companies.

   Manufacturers continue to lose money to the extent that they can no longer pay back banks.

 Manufacturers become addicted to credit. They must keep manufacturing, even at a loss, to keep credit lines in place. At some stage, manufacturers must increase borrowing just to make interest payments.

   The more manufacturers keep manufacturing, the more overpriced polished they produce.

   Oversupply of polished and weak global demand push polished prices lower.

   Banks realize they are not going to get their money back and try to exit, but they can’t. So they keep their credit facilities open, hoping that polished prices will increase and manufacturers will pay back loans.

   Banks confronted with Basel III regulations are forced to reduce their credit limit. The diamond industry is seen as high risk, requiring extra compliance and higher interest rates and banking fees (see “Improved Profitability, Transparency Equals Bankability,” page 60).

   Manufacturers begin to panic and lose confidence. They don’t know how to keep the game going and don’t have the money to pay back the banks.

   Trading stalls and cash flows decrease as large manufacturers refuse to sell at lower polished prices. Manufacturers are afraid that if polished prices fall any more, banks will shut them down and the diamond trade will collapse.

Solution 1: Banks must reduce credit to diamond manufacturers.
It’s obvious that the primary cause of the crisis is excess liquidity in the manufacturing sector. Too much money is chasing rough, which is why rough prices are higher than polished. It’s time for the banks to shut down their money supply until rough prices come down to the extent that manufacturing is profitable.
   Banks must not support artificially high unsustainable rough prices by providing loans for uneconomic activity. Such high prices have destroyed the level playing field by making it impossible for firms to profitably manufacture. What is a legitimate diamond manufacturer to do if rough prices are higher than polished prices? He is being forced to stop manufacturing because of high rough prices. Good people are being forced out of business by irresponsible banks.
   It’s time for the banks to have an honest, “transparent” conversation with their clients and credit committees. No more making believe that everything is okay and still funding yet more unprofitable diamond manufacturing. Such funding makes matters worse and adds fuel to the fire by increasing polished supply that further depresses polished prices. If banks want to wait out these times of diminished demand and speculate that polished prices will significantly improve, that’s fine. But please, no more financing of unprofitable manufacturing.
   A word to the wise in India’s government and banking sector: We realize India’s diamond cutting sector supports the livelihood of millions of people and that significantly reducing manufacturing activity may result in short-term unemployment and hardship. The most likely outcome of denying credit to unprofitable activity is a short-term decline in diamond manufacturing, followed by a significant reduction in rough prices sufficient enough to ensure a profitable and sustainable Indian diamond cutting industry. Continuing on the current course of action whereby unprofitable activity is financed destroys the ability of rational and small, nonfinanced firms to manufacture diamonds and harms the market for millions of Indians who rely on diamonds for their daily bread. I urge you to implement rational credit restrictions.
   If banks deny credit to unprofitable activities, sales of overpriced rough will plummet as funding dries up. One or both of two things will happen: One, rough prices will decline, enabling profitable diamond manufacturing and/or two, mining companies will keep rough prices high and sell less rough. This will reduce manufacturing activity and create shortages of polished. Polished prices will increase due to shortages. Either way, the markets will be moving toward a correction and manufacturers will not be creating losses and dumping more diamonds into the market. The trade may not make money in the transition but they will be minimizing their losses while setting the stage for improved market conditions.

Solution 2:
The trade must support polished prices.
   The diamond trade must prioritize the purchase of polished diamonds over rough diamonds. It makes no sense to buy rough that is more expensive than existing polished. Buying polished instead of rough has a double benefit. It supports polished prices while reducing the amount of new polished entering the market. It dries out the market, creating shortages that enable future polished price increases.
   The current crisis of confidence in the manufacturer and dealer markets is the result of uncertainty about polished diamond liquidity. Dealers do not know at what price they can sell their polished diamonds. They do not see a price floor and are therefore afraid to buy for inventory. When dealers stop buying, trading volumes decrease, liquidity dries up and markets begin to freeze up. That is the danger we face now.
   The solution is for the trade and Rapaport to work together to promote liquidity and confidence by establishing and communicating firm bid price levels with reliable floor prices for polished diamonds. If buyers know that they can sell, then they will have the confidence to buy.

Transparent Competition
   About seven weeks ago, just before the Hong Kong show, a number of large Indian diamond manufacturers decided to price the diamonds they offer for sale on RapNet (the Rapaport Diamond Trading Network) at full Rapaport List prices. The Indians, concerned about deteriorating market conditions and losses, believed it was important that they stop competing with each other on RapNet. They felt that price competition was bad for their business.
   Some market players saw this as a protest against Rapaport, but in my view, I saw nothing wrong with companies pricing diamonds any way they wish. The whole idea of RapNet is that the trade quotes specific independent asking prices that are not based on Rapaport opinion. Our policy is not to interfere with any pricing on RapNet, other than to require that all diamonds under 4 carats have some price.
   The pricing change by the large firms was interesting, as it moved their listings down on RapNet and opened up new opportunities for smaller companies whose diamonds now received more prominent and competitive positioning. When surveyed, some of these companies reported a 30 percent increase in sales. This is in spite of relatively poor market conditions. The lesson here is that smaller firms play an important and vital role in downward-moving markets. They are the core of our business during difficult times. I strongly encourage all firms to price diamonds any way they want and I am pleased that smaller companies are able to use RapNet to grow their business while larger companies still serve and attract customers the way they want.
   On April 6, a number of Israeli companies also began listing their diamonds on RapNet at full Rapaport List prices. The Israelis announced that they were doing this in protest against downward movements in the Rapaport Price List. Since then, there have been formal requests that we stop regularly publishing the Rapaport Price List and boycotts of our services by some Israeli firms.
   While my heart goes out to all the firms suffering from adverse market conditions, the Rapaport Group will remain true to its mission and has issued the following statement:

“A fundamental value, purpose and function of the Rapaport Group is to create, promote and support fair, transparent, competitive and efficient markets. We recognize that many diamond suppliers are under severe financial pressure and oppose transparent competition, which they believe reduces their profit margins. While we sympathize with the difficult market situation suppliers are experiencing, Rapaport remains firmly committed to maintaining transparent competitive markets and honest pricing at all times, including during periods of declining prices. We believe that buyers and sellers must have access to fair price information in declining markets and refuse to restrict the flow of our information to suit the needs of suppliers who wish to protect their profit margins at the expense of buyers. We believe in fair markets and reject the notion that the interests of suppliers are more important than those of buyers.”

   Having said this, we should recognize that many diamond suppliers are against transparent price competition. Would our industry be better off with less competitive price information? Are efficient, informed markets the enemy of profit margins? As stated above, I think the opposite is true. We need more customers and the confidence that better information will help create. Our intention is to move forward not backward. Specifically, we call on the diamond trade to work with us to establish a firm bid/ask market that will build confidence and significantly expand the diamond trade.

The Bottom Line

   The current market situation is not as negative as many of the suppliers think. Polished diamond prices have come down as expressed on RapNet and our Rapaport Price List, but they are stabilizing. The fact that approximately 30 percent of rough was rejected at the last De Beers sight is comforting because it shows that the industry is behaving responsibly by reducing supply as demand declines. Furthermore, declining rough purchases reduce financial pressure on suppliers, making it less likely that they will have to sell off existing polished inventory at below market prices.
   While there is an oversupply of diamonds throughout the distribution system, U.S. demand is consistent and other markets are continuing to make purchases. We anticipate a slow draw down of inventories and relatively stable market conditions provided that there are no significant supplies of new diamonds introduced into the market.
   Diamond suppliers are encouraged to calm down, be patient and let the market correct itself. Some have seriously overextended themselves and may have to take losses and wait out the situation if possible. Do take care of your employees as best you can.
   While we encourage bankers to restrict credit to profitable enterprises, now is not the time to call back loans and force companies to dump inventory. Keep a steady hand. Be careful about extending new credit, as you do not want to finance new supplies into the market until demand conditions improve.

   No one can blame De Beers or other miners for taking the money offered to them. In any case, this is a good time for miners to lay low and not put any pressure on the market to buy new rough. Keeping prices high and selling less goods seems to be working for now, but it is not sustainable over the long term. When demand returns, miners should consider increasing supplies to the market by dropping prices about 20 percent. Manufacturers need healthy profit margins to sell diamonds. If miners strangle their customers and bypass the middle markets, they won’t be able to sell their diamonds in the future. Miners must adopt a live and let live strategy. Recognize that the game with the banks is now over.
   To the buyers, relax and ignore all the noise coming from the suppliers. Concentrate on buying what you need when you need it. Expect shortages as the quantity of new diamonds being produced declines. Talk to your merchandisers about being more flexible and designing jewelry that uses a broader range of sizes and qualities.

Article from the Rapaport Magazine - May 2015. To subscribe click here.

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