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Paying the Price of Not Taking Control

Paying the Price of Not Taking Control

In the wake of the alleged scam by Nirav Modi and his uncle Mahul Choksi, a series of steps are being implemented in India, and none assume that the diamond industry is acting with integrity, transparency or reliability. Of course, most diamond trading companies in India and around the world adopt high-standard business practices, but all it takes is a few to act otherwise, and that there be a constant stream of these “few” for everybody to pay the price.

 

According to the latest reports from India, government-owned State Bank of India, India’s largest lender, is tightening controls around borrowers in the local diamond and jewelry sector by telling their clients  to either bring in more collateral to back the existing borrowings or reduce the size in a timely manner. The Reserve Bank of India announced  that it is banning the use of letters of undertaking (LoUs) and letters of comfort (LoCs). LoUs and LoCs are two of the instruments issued by Indian banks to domestic importers to receive foreign exchange from banks abroad at a cheaper rate. LoUs and LoCs were used by Modi Choksi in their alleged fraudulent activities.

India’s Finance Ministry directed government banks to investigate all default accounts of more than 500 million rupees ($7.67 million) for possible fraud and report the cases to the Central Bureau of Investigation (CBI). In addition, the Indian investigative authorities are looking into “Late night parties at plush farmhouses and hefty kickbacks to top bank officials” calling them two 'compulsory' requirements to access loans from banks which these bank officials should have known would turn into default accounts, or Non-Performing Assets (NPAs) in Indian banking terminology. The challenges extend beyond India’s borders. One of the outcomes is that global funds are selling Indian bonds at an accelerated rate.

Beyond local banks reassessing the nature of their dealings with the Indian diamond industry, there is growing concern in the diamond industry that additional fraudulent cases of using LoUs will be exposed as the investigations move forward and widen.

Internally, Indian diamond traders already feel that the banks have become much stricter in their dealings with them. As it is, most banks lending to the Indian diamond industry have begun trying to reduce their exposure to diamond firms.

Publicly, one outcome of this case is that the entire Indian diamond industry is now suspect. For years, the Indian diamond industry has been pleading with India’s finance and commerce ministries to ease financial burdens – from replacing taxation on profit to taxation on turnover to cancelling levies on imports and exports. For years, the Indian government resisted these demands. With the latest scandal looming over the entire Indian diamond and jewelry industries, not only will they have a hard time coming back to the government to ask for its assistance in doing business, now they may need to face a series of government decisions that will harm them just because they are suspect.

To protect themselves, diamond companies have formed a consortium to ensure banks do not pull the plug on the market and have started holding talks with the banks. That reaction is possibly a classic example of too little, too late. And please do not say you are surprised by this outcome. I have warned of this time and again.

 

 In July 2016, I warned that heavy , a common practice among diamond traders in India, is a recipe for disaster and a dangerous situation for our industry, not because a company may find itself in a situation of defaulting, but because there are many companies that are incredibly overleveraged so if they fall, they will drag down the many companies to whom they owe money with them, hurting the banks in the process. Banks hurt in such a way may choose to reduce their exposure to the diamond industry – not just by reducing financing to poorly-managed companies, but by cutting off prudently-managed companies as well. Isn’t that what is happening now?

“An oversupply of financing and credit in the wrong hands might lead to wrong decisions in any industry, and especially in the diamond industry, which is by nature more abstract,” I warned. At the time, the concern was that bad economic times external to the diamond industry may happen. In this case, the bad economic situation is a result of an internal diamond industry hand – but that does not really matter when in terms of the impact on the industry, which is to drag many firms down. The lesson I was hoping to pass on was that bad situations have happened in the past, and will happen again in the future, and therefore we should act with caution.

At the time, I also warned that while most banks that are subject to the Basel regulations pulled out or are in the process of exiting the diamond industry, the largest volume of financing is coming more and more from banks with lighter regulations and is being provided to manufacturers in India.

I’m pointing out over-supply of financing because the alleged fraud case is an ugly and twisted evolution of the drive for bank credit and loans that is disproportionate to the real financial needs or scale of operation of a business. Financing at all costs.

It is clear that some things will change. Transparency will have to improve, for example. Also, banks have not yet actively reduced credit, so a liquidity crunch has not hit the market yet.

In the movie The Big Short, we see how the US economy nearly collapsed by doing things that we know to be wrong. The movie explores how one basic principle determines the outcome of a play. On Wall Street, it was the subprime play and how everyone took part in it, even though the fundamental truth was, or should have been, known to anyone familiar with the mortgage market – that it is not healthy. The result was a massive economic fallout. Those who studied the mortgage market, the structure of the subprime packages, paid attention to the details and stuck by what they knew reaped the rewards when the truth, the market fundamentals, which became impossible to ignore.

In June 2016 I stated  that we all know that something is wrong in the diamond industry, yet most continue to play it. We all know that messing around with financing will have a negative outcome, and no surprise, that negative outcome is here.

Companies acting fraudulently can hurt the diamond industry as a whole. In the latest case, it is the banks that lost money, not the industry, not directly. But this might as well have hurt diamond firms directly. There are only so many losses that banks can and are willing to sustain from an economic sector. At some point, they learn their lesson and decide to reduce risk by supplying less credit against greater collateral and secured assets. This is what is already happening. The next step is to stop financial backing altogether. That is right around the corner. Other financial institutions will look at the string of negative outcomes and may conclude that the diamond industry is a high-risk sector and decide not to work with the sector at all. That is the unseen damage that we will not be aware of – but pay the price for any way.

Just as this unethical behavior could lead to other harmful effects, and not necessarily to the companies that perpetrated this, other unethical behaviors such as mixing undisclosed lab-grown goods into a parcel of natural diamonds, will leave a trail of harm in their wake. Good, established companies that act with caution may find themselves inadvertently caught up in the trail of mayhem irresponsible companies leave behind them, dragging them down into a financial whirlpool. Not only has the leadership of the Indian diamond center needed to take steps to stop others from causing harm, the entire diamond industry should address it, because what hurts one diamond center hurts all diamond centers.

Another conclusion we should draw from this unfolding situation is that consumers are hearing of this too – and judging us for it. This judgement is not limited to the fact that a something of the magnitude of $2 billion happened in the diamond industry, but also how the industry responds to it. We cannot survive as an unethical business. In an unethical business environment, there is no way to generate long-term return on capital. An unethical business will engender longevity.

I must emphasize again that most companies are ethical. Ethical companies act with restraint and cautiously. A healthy business requires less dependence on bank financing and more on self-reliance, strategic thinking, maximizing profit and return on investment. A healthy commercial endeavor in the diamond sector means having the ability to mine diamonds, sell a rough diamond, polish it in its entirety and sell it to retailers with a good number of customers interested in diamond jewelry. This is done while generating profit at every stage of the pipeline.

We need to keep our standards high, our business acumen in check, our financial lending within reason, our rough diamond costs reasonable, our polished diamond prices at a profitable level, our activities legal, and our affairs in order. Only then will we benefit from a sustainable business environment.

 

 The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser. 

 

 

 

Diamond Portraits: Alfred Beit
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