Debts Are Dangerous In A Deflationary Environment

In a recent presentation, Marcus Randolph, BHP-Billiton’s chief diamond executive, noted that since 1970 rough diamond prices (in real terms) have doubled, while the price of zinc went down 50% and that of copper some 75%.  Though diamond prices have still not yet recovered to their peak level of the late 1980’s or early 1990’s, the impressive performance of the diamond industry in comparison to other commodities, makes diamonds “an attractive business,” according to the mining executive.

I have become scared about the continued reassurances by industry leaders on the comparative strength of the diamond commodity, because this naively ignores the fact that in the past the diamond industry was “supply controlled”, and, mostly in an artificial manner, prices always grew and grew. In Johannesburg (at the WFDB presidents’ meeting), the manufacturers reiterates their commitment “to free market principles”, also ignoring that their product has never been subject to truly free market forces. (I wonder if anyone has actually researched the impact of a reduced custodianship on the diamond industry.) What we have seen in recent years (with semi-controls still in place) is a steep decline in rough prices in 2001, followed by continued rises in 2002 and 2003. We are convinced that much of the market behavior was induced by the demand for polished, but to a large extend by other reasons. Why is this relevant today?

First of all: the industry’s bank indebtedness. This debt has (in the major cutting centers) gone up to some $7.5 billion, and probably more, from $5.9 billion at the beginning of 2002. As interest rates are low, most diamond merchants aren’t worried about this debt. Secondly: in a non-controlled market environment, it is inevitable that the price behavior of rough diamonds will change – and will be far more in line with other commodity prices.

In the “real world” economists express concern about the risk of global deflation – a decrease in the general price level of products, commodities, wages, etc. The world faces deflationary environments in mainland China, in Japan, in a number of Asian emerging markets, while very low inflation in Europe has given concern that deflation may hit that continent as well. Deflation is characterized by a decline in the prices of assets, while the value of cash increases, i.e. one buys more assets with less money. If diamond prices decline, real interest rates go up – without necessarily noticing it. The high industry debt finances assets (diamonds, collateral) which depreciate in a deflationary environment. In situations where labor costs are rigid (locked or sealed by agreements) and prices are falling, the “real labor cost” actually goes up and international competitiveness is reduced. In a way the creditworthiness of a business declines in such type of environment.

Now you might say: the producers are increasing the price of rough all the time, so why this nonsense about falling prices? There are several reasons. I believe that at the consumer level in the diamond industry, we do already see deflationary trends. In 2002, according to De Beers statistics, the number of pieces of diamond jewelry sold worldwide rose by 6%. However, the average price paid for these pieces went down by 3%. Total retail value went up by 2.5%, but the diamond value generalized per piece went down by 2%. There may be many ways one can interpret these phenomena, attributing them to the greater discounting by retailers, the continued downgrading of the market to cheaper diamond ranges, etc. But the divergences between the rough and polished price trends are too significant to dismiss.  And in the present economic environment, this divergence is a serious cause for concern.

Economists tell us that low inflation (less than 2% or so) may increase the risk of deflation. Executives at the DTC will tell us that the greater sales of rough (i.e. greater demand for rough) is the result of the “ripple effect” in which a small increase on the demand side of polished may trigger a higher corresponding increase in rough off-take. However, for the ripple effect to swing upwards towards greater demand at the rough side, it is imperative that trade sentiments are positive. We are not sure that this is the case – not sure at all.

It is not unreasonable to argue that diamonds, in the months and years ahead, will behave far more like other commodities. If the “unit prices” generalized by the diamond industry continue to fall, the deflationary pressures become more profound. The high banking debt will start haunting us all – and the resulting defaults shouldn’t come as a surprise. Though Federal Reverse Chairman Alan Greenspan has noted the “latent deflationary pressures” and called for “addressing them before they become a problem”, most European politicians and economists don’t see overly concerned.

We tend to believe that it is better to be safe than sorry. In a deflationary environment it is better to have cash than assets. The most terrible thing is to have borrowed to finance goods whose prices may fall or be uncertain. The high industry debt is discomforting; the divergence or “discrepancy: in rough and polished prices are certainly worrying; the high and hot rough prices we presently see don’t seem to be justified by either consumer demand or the trend in polished prices. There is no immediate reason for alarm. But Japan should teach us something. In that economy prices have declined for five years in a row and this has negatively affected expectations. Deflation tends to have a negative impact on economic activity and affects the consumer’s feeling of “well-being” and desire to spend. That makes the diamond jewelry business exceedingly vulnerable.

Having grown accustomed to an artificial demand-supply equilibrium management, the diamond industry has never been too concerned with the economic hazards inherent to low inflation and deflation. It should.