By Chaim Even-Zohar

 

The economic slowdown will impact the entire diamond pipeline, but each will be impacted in a different way – with the diamond cutting centers taking the more severe beating, together with the producers. The economic phenomenon that explains with considerable certainty the ways diamond and players are going to be affected is the “ripple effect” – a theory that has proven itself over time within our industry.

 

One might remember 2001, a difficult year for diamond industry, which began against the background of a weakening global economy and an excess inventory of polished diamonds, held mainly by the U.S. trade. This is quite comparable to the situation we began to face in 2008, as the housing slump and subprime crisis commenced in 2007.

 

In 2001, the economic uncertainty was aggravated by the terrorist attack in September; in 2008 we faced the liquidity crunch and banking defaults beginning in September. However, in 2001 Christmas season retail sales of diamond were still above expectations. In the crucial American market they were slightly better than Christmas 2000. Consequently, the reduction in global retail sales in 2001 was less than had been feared; it was down only by some 5 percent over 2000. At the same time, sales of rough diamonds by the DTC, the marketing arm of De Beers, were 21.5 percent lower in 2001 than in 2000. Rough prices, in some categories, plummeted by 30 percent.

 

If a consumption decline of only 5 percent will be the end result of 2008, I think we should consider ourselves lucky. We better embrace ourselves for more. The liquidity crunch and economic uncertainties are greater (and globally wider) now than they were in 2001. What we saw in 2001, and what we saw in 2008 and will see in 2009, was that de-stocking by the retail trade and lower demand for diamond had a negative impact on the rough diamond market in the form of downward pressures on rough demand, downward pressure on prices, shortage of liquidity and reduced profitability.

 

How the Ripple Works

The ripple works both ways – both in a growing and in a falling market. It is premised on the facts that under certain circumstances, increases of diamond retail sales of a few percentage points, let’s say 5 percent, may well trigger a correspondent rise of industry rough diamond off-take of some 15 to 20 percent. The reverse may also be true, as we saw 2001: a small decline in retail sales, in conjunction with negative trade sentiments, may cause a substantial fall in demand for rough and cutting centre polished diamond sales. This occurrence is known as the ‘ripple effect’ and the ‘reverse ripple effect.’

 

How does this phenomenon manifest itself? If it takes an average of 22-26 months for a diamond to move from ex-DTC level to the consumer, this means that the total normal pipeline stock level is $36-$43 billion (rough and polished, expressed in wholesale polished prices). This figure is of vital importance, and means that at the retail level it takes almost one year for the inventory to be turned over (in some places it is slightly shorter).

 

If consumer purchases decline, the need for the retailer to replenish stocks falls accordingly. Depending upon trade sentiment, he will also be satisfied with a lower level of stock. Thus, a small reduction in retail sales will trigger a far greater decline in the level of replenishment. These dynamics will be repeated at every intermediate level of the diamond pipeline. This explains why a 2 to 3 percent decline in the diamond jewelry retail market, coupled with a negative trade sentiment, can cause a 20 to 30 percent reduction in cutting centre sales.

 

This is the ripple effect. Take a hypothetical example (see following table): A retailer whose stock turns around once a year has an opening stock of diamonds of $100,000. His sales also totaled $100,000. In the next year, he sells $120,000, i.e. a 20 percent increase on the preceding year. Being optimistic about the future, he wants to have a stock of $120,000 at the year-end. Consequently, his diamond purchases went up that year by 40 percent, from $100,000 to $140,000.

 

Now let’s look at a different scenario in which the market falls. In the third year, the retailer’s sales declined by 10 percent to $108,000. Because of his now pessimistic view of the economy, he feels that his stock level should be adjusted in line with his sales volume. In such a year, the retailer’s diamond purchases from his wholesale supplier would plummet by a figure much greater than 10 percent (in this hypothetical view by 31 percent).

 

What happens in the retail sector also occurs in diluted form at each stage of the pipeline, and this causes steep rough diamond sales fluctuations in the cutting centers.

 

 

Diamond dealers in the cutting centers almost “intuitively” live the Ripple Effect. The World Federation of Diamond Bourses, among other organizations, appealed to the producers to reduce sales to the market and De Beers announced in October that it would decrease output this year (and concentrate on mine maintenance projects at the expense of maximizing production). As the rough market is more demand-driven today than it was in 2001, or, to be more precisely, as the “rough placing power” of the producers has lessened, diamond manufacturers feel less compelled to buy goods they do not need than in the past.

 

One of the problems the industry is facing this time around is the suddenness and severity of the economic crisis, introducing exacerbating factors. The credit crunch stymies businesses on each level of the pipeline. We are mostly concerned with the industry’s “front line”: the retailers. In Europe and the U.S. there are already reports about credit lines being slashed – when a retailer doesn’t have the funds to replenish, he simply won’t. He will have less goods to offer – and will sell less.

 

A bad season will dampen the retailer’s confidence. Combined with the credit crunch, and given the negative sentiments, he will replenish at significantly lower levels early this year. That’s the Ripple Effect at work. At this still early stage, we can only quote the stewardess who demanded that we fasten our seat belts and sit tight. We are in for a very bumpy ride.