The Real Cost of Round-Tripping

The sudden decision by the Indian government to tax polished diamond imports has surprised many in the country's diamond industry, although it should not have. For a number of years, the government and leaders of the industry warned against the practice of round-tripping – the multiple import and re-export of the same goods for the purpose of getting additional financing from banks.

It must be stated from the outset that this is not a practice that all Indian companies are involved in, just some of them.

The Indian diamond industry has been asking its government to change the way it is taxed. Instead of being taxed on profit, like most other industries, it sought to be taxed on turnover, like the diamond trade in Israel.

In May 2007, the government made a half-step measure and removed the three percent duty on polished imports. From then on, round-tripping became an economical practice; a way to make money from diamonds in a completely new way.

In the fiscal year ending March 31, 2011, India's gross polished diamond export was $28.22 billion. To put this in perspective, the value of diamonds sold by retailers worldwide in 2010 was "only" $18.2 billion, according to a Tacy estimate. During the same period, India imported $12 billion worth of rough. The industry, contrary to popular belief, does not double the value of rough, far from it. The export figure is clearly inflated.

Net exports in the year were $7.41 billion. It would be inaccurate to conclude that there is $20 billion in annual round-tripping (gross exports less imports). Many traders show goods to clients, who buy some of them and return the rest. We estimate the ratio of such returns at about 1:2.

For example, 55.5 percent of diamonds exports to the U.S., valued at $1.79 billion, remained there with 44.5 percent by value returned. Of the $1.68 billion exported to Belgium, 46.4 percent was returned to India and only 28.6 percent of exports to Israel were shipped back.

So where are the goods going? Mainly to Dubai. The UAE, India's top export destination, kept only 6.8 percent of the massive $12.43 billion worth of polished diamonds it imported from India. The rest travelled back and forth between India and the UAE an estimated four or five times before they finally moved down the pipeline.

If goods were smuggled back from Dubai before duties were abolished in May 2007, an illegal practice and therefore limited in scope, after the import duties were removed, parcels moved freely and round-tripping became more widespread.

This partially explain how gross exports to the UAE that totaled $1.14 billion in 2006 and $1.65 billion in 2007, nearly doubled to $3.11 billion in 2008 and mushroomed to $4.46 billion in 2009. By the way, the years 2008 and 2009 were the first difficult years of the global recession.

If normal trade practice requires that for $1 million worth of goods sold, $2 million worth of diamonds need to be exported, gross exports to Dubai should be about $1.7-$1.85 billion (as net exports were $842 million), not more than $12 billion. This indicates that the value of round-tripping was about $10 billion in fiscal 2011.

If a parcel makes at least four round trips for the sake of financing, this means that for every $1 million worth of goods the exporter gets $4 million in financing. Not bad as long as you can pay it back. However, considering that this heavy financing is borrowed without having an equal amount of collateral behind it, the diamond-financing banks in India are naturally getting jittery - and that is bad for the business. The central Indian government does not want a major financial collapse on its hands. In addition, some small to mid-sized diamantaires not involved in round-tripping may find it difficult to gain access to the credit they need to do business on a normal basis and rightly deserve in an open economic environment.

While industry representatives met with the central Indian government to urge it to switch to a turnover tax, something that would have curbed the round-tripping practice, the government was seeing how its half measure was backfiring. Instead of completing the move and approving turnover as the basis for taxing the firms, the government took a step back and decided to immediately reinstate the import tax, levying a two percent duty.

At the same time, the government also changed the import duty on gold to two percent of value instead of the flat Rs 300 (~$5.90) per 10 grams. This move was taken for two reasons: The first was to battle flight of foreign currency, but the second, according to insiders, is to slow gold round-tripping.

There is a message here. The once tolerant central government and banks are taking a new, more active role, in stopping practices they consider as harming business. They are moving slowly, but decisively. Traders should act prudently, as this is a sign of things to come.