Russia: In Search of a Future Without De Beers
December 28, 06With 2007 fast approaching, many of us are wondering what will the next year bring? Some answers to that question are obvious: De Beers will drop Supplier of Choice and replace it with something else; the reduced intake (and obligations to support beneficiation in African countries) will lead to a dramatically reduced DTC client list; the liquidity and synthetic issues will continue to create debate. These issues are all self-evident. What is less obvious - and probably by far the most important issue the industry will be facing – is what will happen in Russia.
After having re-taken control of the oil and gas industries, President Vladimir Putin is now in the final stages of reasserting the Kremlin’s control over the diamond business through the reorganization of the shareholdings in Alrosa. Putin had made it clear that he wants to secure (for the federal government) a majority shareholder position of 50 percent plus one share in Alrosa. In fact, he will probably end up securing close to 60 percent, with the balance in the hands of the government of the diamond mining republic of Sakha (Yakutia).
Currently, the (Federal) Russian Property Agency owns 37 percent of Alrosa, the Yakutia Property Ministry holds 32 percent of shares, eight districts in Yakutia own 8 percent, and the company’s employees hold 23 percent. Since mid-2006, the Vnestorbank (VTB) consolidated some 10.5 percent of the shares it had bought back from minority shareholders. These shares will end up in the federal government’s hands at the end of the process. Negotiations over the value of Alrosa have ended and the consensus seems to be that its value is a total of $8.7 billion. Having an agreed upon value is a prerequisite to the redistribution of shares and/or the issuance of additional shares.
The current management of Alrosa, headed by Alexander Nichiporuk, is undoubtedly a capable and professional team on the international diamond scene. However, if we have learned anything from history, when politicians have the final say, the rules of the games will change. Putin’s predecessors depended heavily on diamond revenues for political purposes and, partly depending on whether he wants to change the constitution to run for an additional presidential term or not, there is no reason to think that he will be any different. But it goes beyond that.
For the first time in the history of Russia’s diamond industry, it will not be part of the De Beers marketing cartel. When rough supplies exceed demand, Alrosa will have to compete head-on with De Beers. No restraints. What will this do to the diamond industry?
Let’s look at the figures. Russia is the world’s second largest rough diamond producer. The country produced some 38 million carats worth, $2.26 billion in 2005, which corresponds to some 25 percent of world production.
Ever since 1959, when the former Soviet Union commenced sales from its first mine, in the early days of the Cold War, the producer has been part of the De Beers marketing cartel. The cooperation went far beyond just marketing and price-setting collusion though – there were financial arrangements, technology exchanges, political links, as well as aspects involving Anglo-American, which was at the time, also the largest gold producer in the world. Oddly, during the Soviet days, the cooperation between De Beers and the Russians was much better than in Russia’s “free market” economy that has evolved since the early 1990s.
Unquestionably, De Beers has viewed the Russians in the past decades as a quite unreliable and unpredictable cartel member. About ten years ago, De Beers’ Gary Ralfe publicly charged “that diamond sales from Russia are dictated more by Russia's need for foreign exchange than by the real needs of the market; that Russia will be prepared to sacrifice on the altar of short terms gains of foreign exchange the long term well-being of the diamond industry, including its own diamond industry.”
Mutual distrust prevailed, and many key government players in Moscow barely hid their loathing for their contractual partners. In 2006, De Beers made what appears to be an irrevocable statement to the EC never to purchase – directly or indirectly – Russian diamonds again after 2009. If we have learned anything from the past, it is reasonable to expect that the Russians will craft a fully independent course and will compete with -- and possibly even undermine -- De Beers’ interests. Aided by the new Archangel discoveries, Russia may also aspire to become the world’s largest producer of diamonds. Russia has already commenced open-market buying operations (in Angola) in order to optimize sales volumes which reached $3.1 billion in 2005 (and this includes African goods, as well as some $143.7 million of polished).
Given the current political developments within the Russian Federation, the government’s leadership will use the diamond resource foremost to advance its own domestic policy agendas.
Just remember: While a member of the cartel, the Russian government didn’t hesitate to flood the markets with both rough and polished diamonds at dumping prices, whenever it served its purpose. If cartel membership didn’t prevent such flooding, isn’t it legitimate to wonder how Russia will act without the ‘restraints’ of cartel membership?
In the post-Soviet era, the Russian diamond industry has faced a continuous internal, trilateral struggle for ‘control’ between the Federation Government, the Russian Parliament, and the regional government of the Republic of Sakha. (Of course, there are also additional deeply entrenched, private (domestic and foreign) and institutional interests at stake.)
Former Sakha (Yakutia) President, Mikhail Nikolayev, once stressed that “during the years of command administrative system, none of the Soviet territories (such as Sakha) could claim its right even to the slightest part of its natural resources. As a result, in the Soviet northeast there existed a vast region that gave the country a lion’s share of hard currency, but, at the same time, deprived of even minimal portions of this wealth that could be spend on its development. There are reasons to say that at the time even the high leaders of the (Sakha) republic had no idea of quantities and the price of diamonds extracted here.”
In a way, Sakha was not all that much different from some African countries where “pay-back time” has arrived. But one must look beyond the power struggle between the central government and its republic – as, basically, in the diamond business, President Putin is already victorious. Yakutia President, Vyacheslaw Shtyrov, who previously served as president of Alrosa, was engaged in a bitter struggle to retain some measure of autonomy over the republic’s vast diamond resources – but he now seemed to have reached a compromise. President Vladimir Putin agreed to support him for re-election in a second term as President of Sakha. In return, it is understood that he will allow the central government a free hand in the reorganization of Alrosa. No easy choices. Moreover, with the elections behind him, nothing will stop Shtyrov to resume fighting for the best interests of his republic.
The reasons for concern about the future are related to the overall Russian dynamics. The Russian Federation is blessed by an abundance of natural resource endowments and the country can be characterized as a resource-based economy. In the last few decades, many economists have come to see natural resources as an obstacle to successful development. For instance, in some countries natural resources have fueled civil wars and conflicts instead of positively contributing to the economies. Hence, the well-known term ‘resource curse.’
Both the Russian Federation as a whole and the diamond republic of Sakha, in particular, are hugely dependent on natural resources. Economists and political scientists tell us that if suitable conditions can be established in an equally suitable economic and political framework, natural resource abundance may advance economic development. But, too often, that is not the case.
In Russia’s situation, the Republic of Sakha has received little benefit from its resource. Its situation is in some ways comparable to some of the ‘failed states’ of natural resource countries in Africa. Resource-based development presents important policy challenges to governments. It is imperative for governments to recognize the diamonds’ vulnerability to external shocks (dependence on international commodity price fluctuations), the risk of so-called ‘Dutch disease,’ and other economic distortions that may evolve from an over-dependence on natural resources. (The term ‘Dutch disease’ is usually used by economists to describe a situation in which a country suddenly discovers large quantities of natural resources and starts exporting them. Dutch Disease can also become a more pressing problem for a country if the weight of an existing resource sector in exports increases relatively fast. The increased resource wealth tends to raise the equilibrium exchange rate and/or general wage levels, thereby putting pressure on the competitiveness of the other tradable sectors in the economy.)
The Organisation for Economic Co-operation and Development (OECD) argues that “resource-based development places a priority on good macro-economic management, particularly sound fiscal policy. Turning to the institutional side, it is stressed that, for a number of reasons, the need for a non-corrupt and efficient state apparatus is particularly great in a resource-based economy and that the creation of such an institutional setting is facilitated by the presence of a strong civil society. Finally, to the degree that a more diversified economy is less prone to the risks enumerated above, diversifying a resource-based economy can also solve potential problems of resource dependence.”
Throughout the years, governmental stewardship of the diamond industry in Russia has been problematic, mostly because the diamond sector did not operate in a vacuum. Corruption, cronyism, and institutional weaknesses that applied to general resource management have clearly not bypassed the Russian diamond industry. Economists have generally concluded there is significant evidence that resource-based development has generally been more successful when state ownership in the resource sectors has been absent or very limited. In the Russian diamond industry, there are liberalization measures that take place simultaneously with stricter government control. One hand gives; the other takes. And, after minority shareholders are being bought out, Russia’s main diamond conglomerate is reverting to 100 percent governmental control.
Changes in the structure of an economy – any economy – are, by nature, relatively slow. Russia’s and Yakutia’s resource-based economies are bound to remain just so for quite some time – and that is particularly so for the ever-growing and expanding Russian diamond sector. Indeed, based on currently known projects, Russia’s diamond output will grow dramatically within the next decade.
The Sakha Republic’s economic dependency on diamonds is comparable to that of Botswana. Within Sakha, the diamond industry’s revenues represent well over 93 percent of all gross foreign earnings of exports. Well over 75 percent of the region’s budget is generated by diamond revenues; direct and indirect employment in diamond-related services is substantial. Since the break-up of the Soviet Union and the establishment of the Russian Federation in which Sakha is an independent republic, the distribution of the foreign earnings between the republic and the Russian central government remains a great source of contention and friction.
Pragmatism always Prevailed over Principles
The modern diamond industry in Russia dates back to the mid-1950s, following the discovery of promising diamond deposits in the Siberian regions that comprised the former Soviet Union. The former Soviet state-owned diamond mining company, Yakutalmaz, was established in January 1957, and sold its first lot of diamonds on the world markets in 1959.
Historically, Alrosa (and its various predecessor companies) delivered those rough diamonds not required for the domestic market to De Beers pursuant to trade agreements that made De Beers the exclusive buyer of Soviet Russia’s rough diamond exports for well over 40 years. In 1959, De Beers bought its first few thousand carats of Yakut diamonds. Details of the early agreement, worked out by Sir Philip Oppenheimer, are not clear. What is clear is that worldwide condemnation of South Africa’s apartheid practices in the aftermath of the Sharpville Massacre, and the growing anti-communist character of the South African government (leading to the breaking off of diplomatic relations) made it impossible for the Soviet Union to renew its contract with De Beers in 1963.
Thus it was publicly announced that Moscow refused contract renewal, when, in fact, the parties tried to hide their continued relationship through the use of a separate company called City and West East Ltd. This company was (and still is) a conduit for the rough diamonds sold to them. (City and West East Ltd. is incorporated in the UK and has top De Beers' executives acting as directors.) The first contract with City and East West was concluded in 1963. This arrangement was even more remarkable since the Soviet Government became strong supporters of the anti-Apartheid movement (and South Africa’s ANC leaders were mostly educated in Moscow – including the current President, Thabo Mbeki).
But ideology did not prevent the Soviets from selling to ‘capitalist’ De Beers. To the contrary: During the Apartheid years, De Beers had convinced the U.S. authorities that it was impossible to identify the origins of a polished diamond – thus effectively neutralizing the South African diamond industry from the economic sanctions on purchases from that country. This move also helped the Soviet Union since, at the height of the anti-communist hype in America during the Cold War, loving newlyweds in the United States never imagined that their treasured diamonds had actually been produced behind the Iron Curtain. The covert relationship was kept secret until 1990.
The 1990s were stormy years for De Beers in Russia. While the Gorbachev period had still been rather good, things changed for the worse when Boris Yeltsin came to power. An investigative journalist wrote “Then [1992] the Russians started to query the CSO’s generosity. A parliamentary investigation found the Central Selling Organisation (as the DTC was called then) made a 200% profit on the Russian diamonds, nearly US$10 billion. Since De Beers valued its own South African production at a carat price three times higher than it paid the Russians, this was not surprising. Suddenly the (US$5 billion trade agreement) seemed less favorable. Boris Yeltsin’s takeover was bad news for De Beers. He had lambasted Gorbachev for signing a contract with De Beers that was unfavorable to Russia. When Harry and Nicky Oppenheimer went to Moscow in February 1993 to open De Beers’ first Moscow office, Yeltsin snubbed them by canceling their appointment to see him at the last minute.”
The Parliamentary Committee may have exaggerated; it may even have been wrong. Still, its significance is that it conveys a sense of the “climate,” the atmosphere in which the diamond business played out in those days. The Kremlin did not really trust (what was then still called) Almazy Rossii-Sakha (ARS) company, despite having a major share in it. Therefore, Yevgeny Bychkov, a close associate of Boris Yeltsin, was appointed chairman of the Russian Precious Stones and Metals Committee (Komdragmet). This entity controlled the Russian stockpile and was entrusted with checking the buying prices of De Beers. In an interview with this author, Bychkov replied to a question about his relationship with the ARS. He said as follows: “How can you speak of relationship where one party is working just for De Beers and the other party is working for the State of Russia. De Beers likes ARS, but we don’t like the way they do business.”
Bychkov was later implicated in some mega-scandals, and from a historical perspective, this may put his statement in a different light. It is crucial, however, to understand the continuous intrigues in Moscow between the various pillars of the diamond industry: the governments of Yakutia and the federal government, Alrosa, Komdragment, and various other players. So with the benefit of hindsight, it must be stressed that in the transition process from a centrally planned economy to a free market economy, the Russian Government did not lose control of diamonds. However, its policies were, at many times, not conducive to market stability.
The 1992 to 1995 period, after the 1991 dissolution of the Soviet Union, was one of near anarchy, characterized by a general lack of direction and coordination in the management of the Russian diamond industry. The closing of Glavalmazzoloto in 1991 left the industry with no effective coordinating body. In 1992, Almazy Rossii-Sakha (ARS) – later renamed Alrosa – was established as a closed joint-stock company by Russia and Yakutia in order to manage the production of rough diamonds in Russia. The marketing arrangements, however, were still set by governmental decree. Stability and consistencies in policies were restored in 1996 when industry-wide efforts to consolidate resources commenced in earnest.
Once established, Alrosa played a pivotal role in contributing to the development of a medium to long-term policy of restructuring and modernizing all sectors of the Russian diamond industry. Moreover, since then, Alrosa has been the main industry party engaged in continuous dialogue with both the Government of Russia and De Beers. The latter welcomed this situation since, during the communist, centrally controlled market system, it was far easier to deal with government than in the post-2001 days.
The last formal Trade Agreement (December 2001), which provided for Alrosa’s annual sales to De Beers of up to US$800 million over a period of five years, was presented to the EC’s Competition Authorities for approval. This approval was denied. A Statement of Objections was issued that basically required both parties to come up with revised proposals. This led Alrosa and De Beers (in mid-2003) to agree to a phasing out of sales until an annual residual minimum sales level of $275 million would be reached in 2010. It was envisioned that, at this level, De Beers could continue to purchase from Alrosa from 2011 and beyond.
We’ll never know whether the EC would have agreed to that. At some point, De Beers made a separate commitment to the EC agreeing to totally stop dealings with Alrosa; the EC decided to accept De Beers’ commitments. The file was then closed without addressing the commitments proposed by Alrosa.
Reportedly, the Russians are incensed that this De Beers commitment was made without the consent of Alrosa. So, though the Russians are intensively preparing for marketing without De Beers and are establishing a range of Alrosa sales offices around the world, the company has nevertheless appealed to the European Court to get an annulment of the EC decision to terminate the De Beers-Alrosa marketing arrangements. De Beers has not challenged the EC’s decision and seems to be content to market only its own output.
Thus, Russia is currently in the final days of the countdown to its separation from De Beers. The year 2009 will mark the first year ever in the history of Russia’s diamond industry that the country will no longer market a single stone through the diamond cartel. This termination will effectively end price fixing and policy co-ordination between the world’s two largest diamond producers.
The now virtually inevitable end to the De Beers/Russia relationship represents an odd quirk of fate. During the 50 years of partnership, especially in the final decades, Russian parliamentarians, trade and government officials often stressed that “Russia has been taken for a ride,” that “Russia’s client (De Beers) was setting its own buying prices and these were often 30 percent or more below market price.” To say that the relationship was often antagonistic and acrimonious is an understatement. But now, when the relationship is nearing the end, Russia’s government is resorting to the courts to see whether it is still possible to reverse the inevitable. This is not likely to happen.
In recent years, the Kremlin has not clearly outlined its vision for the future. Alrosa’s supervisory council, headed by the Federal Finance Minister and Alrosa president Alexander Nichiporuk, has been setting their own agenda. Whenever President Putin assumes control, he will have to define the commercial targets and strategies of the company. Putin would not fight so ferociously if he was truly happy with the direction the business is taking today.
While working with De Beers, Alrosa often pursued its own interests in total disregard of its partner’s needs. It is going to be interesting to see how Russia will act when the country owes no allegiance to the company to which it has sold its rough output for the past fifty years. It will also be interesting to see what will change in the Yakutia-based mining company when formal control is transferred to the Federal Government – which, in many ways, represents a major step backwards from a Yakutia perspective.
We probably will not have to wait long to get the answers. As with many things in life – let’s hope for the best, and prepare for the worst.
Happy New Year.