“Liquidity risk management is of paramount importance, because a liquidity shortfall at a single institution can have system-wide repercussions.” This is a quote from the governor of the Dutch central bank, Dr. Nout Wellink, (who also serves as chairman of the Basel committee on banking supervision.) Forget about the underlying causes of the current economic crisis, what actually brought down giant banks in a matter of hours rather than days was a sudden lack of liquidity. They had no cash, nor anyone willing to lend it to.

What Wellink said about the banks is in many ways also true for the very capital-intensive diamond industry. A review of major industry bankruptcies in recent years shows that these were triggered by a combination of mismanagement of assets (money, stocks) and the resultant cash flow problems – exacerbated often by a bank that tries to be the first to put hands on collateral. Too many diamonds – too little cash.

Relatively speaking, major diamond industry corporate bankruptcies are rare and this is something which should give all us a measure of comfort in these trying times. Our worldwide banking debt today is between $19-20 billion. This debt does not only include the major centers where the same debt levels continue to be rather stable, but also funds taken in Moscow, Dubai, Switzerland, Germany, England, Hong Kong, Singapore and elsewhere.

This banking debt equals one year of worldwide polished consumption at polished wholesale prices in the diamond pipeline - where it still takes an average of close to 2.4 years for a diamond to move from the producer to the consumer. (At the retail level, it takes about one year for a diamond inventory to be turned around once.) Normal world-wide diamond pipeline rough and polished diamond working stocks total some $45-$50 billion at any given time.

If one measures the cross-border transactions of rough and polished per year, which require settlement of international payments, the total annual worldwide diamond trading volume is in the range of $150 billion to $180 billion! Using Kimberley figures that have been adjusted to account for trade between England and Belgium which does not appear in the statistics, one can conclude that rough exports alone account for well over $60 billion and it is fair to assume that every time rough diamonds change corporate hands a financial transfer is involved. When polished, the trade transactions include the added value generated by the rough conversion process.

For our industry as a whole, the total liquidity position seems reasonable for functioning in normal times. This non-diamond crisis caught the industry at a time in which too much of the liquid means are tied up in stock, which may lose considerable value in a severe market downturn. The debt to equity ratio is fine for normal days – but out of balance for a protracted slowdown in demand: too much of the working capital is borrowed money. As the global crisis evolves some parts of the business have already come to a halt and in many places payments have been delayed and checks are bouncing. False rumors are circulating in Antwerp regarding companies seeking borrowing from colleagues, paying mafia level interest rates.

All these phenomena are both expected and inherent to the current market conditions. If one reflects a moment about the number of international trade transactions that take place every year one can only be amazed how smooth our industry payment systems work. In rough trade alone some 60,000 export transaction are recorded by the Kimberley Process – and this excludes the significant trade between England and Belgium.

The still evolving banking crisis impacts our industry in various ways – some immediate and others are long term. Producers and analysts have always lamented that the diamond industry is too fragmented, that it has too many players, that there is a need for consolidation. It is, however, precisely because of this very fragmentation that the financial risks are so widely spread. The industry pyramid is small at the top and wide at the bottom. In Israel, which counts some 1,000 diamond exporting companies, 2 percent of these companies account for some 45 percent of all exports – something which is also reflected on the financing side.

In Belgium, ABN-AMRO's three top clients are estimated to have a joint exposure (including securitizations) of almost $1 billion, below the top of the pyramid the spread is wide and healthy; at the Antwerp Diamond Bank, which serves mostly smaller companies, the three largest clients may jointly owe $350-$400 million. What we have seen in the banking failures is probably also true in the diamond industry: the likelihood of a collapse with system-wide catastrophic ramifications is quite limited to defaults of major players.

This is not a likely scenario – provided things don’t run out of control. There is something which, in the past, bankers would only privately whisper and never officially confirm: there was no chance in the world that a diamond company that owes its banks in the range of $450-$750 million or more will ever repay that debt. They weren’t expected to do so – they were expected to service their debts (i.e. cash flow management) and the companies should only be sufficiently sound to generate the earnings needed to remain in reasonably good standing.

In a way this is comparable to the trade in extremely complicated derivatives which were “virtual securities” where banks made fortunes in the trading, ignoring the quality of the underlying values. It didn’t matter. This is exactly what brought about the gigantic crisis: from mortgages to other collateral, the system saw confidence and value evaporate. It is going to be a new ball-game, with governments largely in charge. What was is not what will be.

Ramifications of Industry Defaults

The ultimate question is to estimate the expected degree of fall-out, the spillover effects, of a mammoth default. It is also hard to predict how much distress selling will occur among cash-tight medium and smaller firms. Everyone (bank, producer, manufacturer) has a vested interest in avoiding mega bankruptcies which could trigger vast industry-wide meltdown in terms of massive liquidation sales of rough and polished, falling prices, and cause a domino effect on a plethora of suppliers in the value chain. Concerted action is required to prevent such scenario at all costs. The question is: who will be in charge?

In the banking crisis, solely to mitigate the potential damage and restore consumer confidence, governments are orchestrating massive bail-outs. And in this there is a huge difference between the diamond business and the banking business. While there is no doubt that the immediate trigger to any crash in the diamond industry will be the result of cash flow problems possibly combined with the inevitable “market rumors” (loss of confidence to sell to the company), the diamond industry doesn’t have a bail-out mechanism. No governments will foot the bill or assume the risks.

If there is one immediate lesson to be learned from the banking crisis, to quote Governor Wellink again, “in advance of the turmoil, asset markets were buoyant and funding was readily available at low cost. The reversal in market conditions illustrate how quickly liquidity can evaporate and [brings the realization] that illiquidity can last for an extended period of time.”

Volvo just announced plans to lay off over 3,000 employees. Responsible firms read the map and take belt-tightening measures. With less money around, consumer spending will go down. This time consumers may not want to spent money they don’t have. An Israeli diamond banker said this week that after the holidays, one can expect a massive tightening of business activities, accompanied by dismissals of non-essential employees, cost savings, etc. It will go beyond just cost savings. Companies will analyze their transactions to measure precisely the profitability of each customer – and become more selective in their dealings. McKinsey research published this week stresses the paramount importance of getting the pricing right in an inflationary downturn spiral.

The rapid decline in the diamond jewelry market, and the decreasing demand that we are witnessing from retailers lacking credit lines to finance inventory replenishment in advance of the holiday sales, are taking place at a time when there is still excess manufacturing capacity and partially mispriced raw material sales and purchases. A decrease in the downstream prices must be offset by lowering upstream costs. Diamond manufacturers and traders are in the middle of a quite volatile shock situation where the inevitable weakening of polished prices cannot be prevented and too many industry players lack the self discipline to refuse to pay the high rough material prices.

The Role of Producers

It is in bad times that one idealizes “the good old days.” Reminiscent of the cartel-days which are long gone, the president of the World Federation of Diamond Bourses, Avi Paz, after consultation with his colleagues in other diamond centers, has this week made an appeal to all the producers to reduce their supplies of rough to the market. In a letter to diamond producers, Paz stresses that “in this period of economic uncertainty, the stability of the world diamond industry is vital to the world economy and to the international banking system. The quantity of rough that is marketed worldwide greatly affects the stability of the industry and the industry’s global bank debt; therefore it is extremely important that the mining companies reduce their rough quota for marketing. Such action is imperative and necessary to the diamond industry as well as to the rough producing countries, the mining companies and the global banking system”.

I fully expect that the producers receiving this letter will shrug their shoulders and ask their secretaries to send a polite acknowledgement. The appeal will be filed, ignored and forgotten by the end of the day. The WFDB should have made an appeal to its members. It should have advised them not to purchase rough at irresponsible prices or rough which is not needed.

True, Diamond Trading Company Sightholders are locked into contracts, as are core clients of other major producers. Obligations must be met, but overpaying must be avoided at any price. Throughout 2008, most DTC boxes traded at significant premiums (upsetting African producers) and the mis-pricing that occurred at some point was largely a result of the speculative trading within the industry of the larger goods and dependence on some erratic near-hysterical price lists (DTC boxes need premiums for clients to meet downstream marketing obligations.)

The highest priced goods to the market came mainly from Russia and Angola, where client-customer relations resemble more of a cowboy-type nature. There is market talk that Alrosa clients want to discuss the last allocations which may have been 15 percent above market price.

Incidentally, it is remarkable that in the diamond industry those who knowingly overpay always have a plausible justification, such as “positioning” with the supplier or “pleasing the DTC”. One should not feel compelled to purchase goods which aren’t needed, if one can (contractually) avoid them. Often they just cause damage to their own interests.

In a downturn market, over-paying for raw materials is the best way to hit the southward road. It is easy to dismiss all of this by saying this is a free market, anyone can do what he wants – and, please, mind your own business. But here again we have to learn from the banks. One player’s own business failure can trigger an industry-wide catastrophe. We have seen the domino effect before. No one will bail out the industry if liquidation sales of a mammoth bankruptcy bring down the price of diamonds similar to the prices of international real estate. Fortunately, there is no need for this to happen.

Industry: Highly Leveraged but in Good Health

In the DTC’s Supplier of Choice profiles, considerable weight was (initially) given to available credit facilities. When someone optimistically forecasted a 100 percent growth of his business to get a larger allocation, he made sure he could show having the financial resources to facilitate such (unrealistic) growth. People received facilities they didn’t really need – but then used them anyway. As the DTC put a heavy weight on return on capital employed as well as return on equity, many players decided to increase leveraging and actually withdraw equity (family money) from the business – and put the equity at use in more profitable enterprises.

Though financially sound, the industry’s reliance on borrowed money is high. In some markets, like India, 70-75 cents out of each dollar of capital employed may come from borrowings. Banks – especially Indian banks – were very happy to extend credit to an export priority sector – especially as defaults were few and small.

The financial situation in the diamond industry is in reasonably good health. Especially in the larger goods, players made money in the past few years, even though rough prices grew faster than the resultant polished. Liquidity pressures on the industry will come from the two extreme sides on the value chain:

(1) Producers which face higher mining costs and simultaneously need to finance transformation to underground mining (Russia, Australia, Botswana and Canada) and are eager to enter into transactions where payments even may be advanced;

(2) Retailers whom are being denied the credit lines needed to finance inventory replenishment. There will be pressures on the in-between downstream players to grant more supplier credits and also make commitments to mining conglomerates.

The industry must embrace itself not only for more expensive credit, but also for a whole “new order” of banking conditions. While some may believe that current events have only demonstrated the relative futility of the Basel II regulations aimed at safeguarding the solvency of the banking system, the relevant authorities say exactly the opposite and stress the need to tighten compliance with this regulatory and supervisory framework.

Banks will look for excuses to reduce facilities and/or to hold up payments. An Indian industry leader mentioned that the troubled Wachovia Bank this week was delaying a payment to an Indian rough exporter as it wanted to verify that the export had a KP certificate… What a lame excuse to delay a payment.

With the evaporation of trillions of dollars of cash in the worldwide economy, access to finance will become increasingly difficult. One Indian diamond bank has already slashed it facilities by some 20 percent-25 percent. Dollar borrowings in the Indian market can be obtained at LIBOR plus 6 percent - a rate that generally is reserved for the highest risk clients.

Orphan Getting Again New Parents…

In the past week, the Dutch government assumed 100 percent control of ABN-AMRO Bank and Fortis in the Netherlands and its International Diamond & Jewelry Group (ID&JG). As ID&JG has now been removed from other Belgian (Fortis) banking interests and is NOT part of any of the assumed Belgian government holdings, it is again unclear what will happen to that group. The search for new parents will likely continue.

The Dutch central bank will remember that the Amro Bank voor Belgie (ABvB) went bankrupt in the crisis of the early eighties; that at the end of 1986 it was bailed out by the Dutch Amro bank (that later merged with ABN in 1991.) No government funds were involved – the Dutch bank took the loss. We would hope that the Dutch will by now be impressed by the ABN-AMRO “comeback”, having become the single largest diamond industry financing institution in the world. But I don’t like the sound of the music. The Dutch government this week publicly accused Belgium for having “infected” the Fortis Bank, creating an atmosphere of “nationalism” within European banking, proudly assuring the Dutch citizens that it had purchased the healthy parts of a troubled bank. In such an environment, the Dutch government isn’t going to care too much about the welfare of the Antwerp economy and its diamond players.

Against this background, I can see little reason why the Dutch government would like to operate an international diamond division. The new Dutch banking entity may lack the infrastructure to do so – even if it wanted it. Thus ABN-AMRO’s International Diamond & Jewelry Division is still a “Happy Orphan”– possibly with less sympathetic (and committed) parents than it had just five days ago. What a difference a week can make…

New Financial Vocabulary? No Laughing Matter

At this time the diamond industry appears to have strength and resilience to weather through the coming downturn. The global crisis is not a diamond crisis. The immediate danger we face comes from the pressures or temptation of passing on the liquidity we have to either the producers or to the jewelry retailers. Liquidity management should become our first priority.

The terms of reference will be different. Actually, even our time-honored financial vocabulary may need a revision. One industry player, in a failed attempt to cheer up his despondent colleagues, provided a glimpse into the financial world’s new terminology. “CEO,” he says, “stands for Chief Embezzlement Officer. A Market Correction is something that happens the day after you buy stocks or diamonds, while Standard & Poor refers to your life in a nutshell.”

When expressing apprehension on liquidity and margins issues, he dismissingly laughed these away. “Cash Flow, he explains, refers to the movement your money makes as it disappears down the toilet, while Profit is an archaic word no longer in use – certainly not in the diamond business.” For diamantaires and jewelers (and their families) the new definition of Bear Market is particularly scary: a 6 to 18 month period when the kids get no allowance, the wife gets no jewelry, and the husband gets no sex. We were also cautioned to stay away from our Broker, who only “will make you broker”.  

Though it evoked smiles, none of this is actually funny. Liquidity is the life jacket which will get us all through the next few years. Access to financing at reasonable terms may become more important then ever. Successful players will manage – and protect - their cash flow and level of liquidity. In the first half of this decade the industry financed and absorbed the “buffer stocks” which the producers dumped onto the market. In the present credit crunch both the upstream and downstream players like to absorb funds from those in the middle – the manufacturers and traders.

It may not be a bad idea to misplace one’s checkbook for a while.

Have a nice weekend.