When the world runs out of diamonds

| Friday May 21, 2010 00:00

For the continent's diamond producers, still dependent on Western markets for over 50% of final retail demand, the outlook has been less certain.

Although sales have recovered from the lows of the crisis, there is little reassurance on the sustainability of demand. The diamond pipeline remains notoriously dependent on the availability of financing, but it is unclear whether an improvement in financing(perhaps subject to new reversals in the short term) or a more sustained turnaround in underlying demand has driven the recent pick-up in sales. Last year, Botswana's economy experienced one of the most severe economic contractions in Africa, declining by 6%. Given the weak base, a rebound in 2010 - with diamond exports having resumed - is a given.  But with the country in its second consecutive year of a double-digit fiscal deficit, having already had its prized single-A rating downgraded by S&P, it is not just the near-term outlook that matters.

Having realised the downside of over-dependence on a single commodity, Botswana has focused its efforts on spending in order to diversify future export revenues.  Ironically, the outlook for diamond earnings remains key to the affordability of this diversification strategy.

De Beers output cut expected to shore up diamond pricesRecent news may be encouraging. Following the crisis-related slowdown, the diamond market saw better-than-expected seasonal sales around Christmas. Continued restocking by retailers underscored demand in Q1-2010, and Botswana's exports are back - if not exactly to cycle peaks, then at least to levels much higher than those seen at the low point of the crisis, when Botswana's mines were forced to shut down for four months (Chart 1). 

Press releases have touted the expected doubling of China's share of the world diamond market to 16%. But the real game-changer for Botswana's export outlook may be the recent unveiling of plans by De Beers to curb output. 

The company, which has a longstanding partnership with the Botswana government (which, in turn, has a 15% equity stake in De Beers), is thought to control around 40% of the global rough diamond market. Officially, the reason for the production cuts was asset sales by De Beers during the recent crisis, which may necessitate reduced output levels. Output rationing will help to reduce running costs amid a hoped-for turnaround in financial strength indicators.

Even diamond (reserves) may not be foreverBut other factors may also lie behind the planned cutbacks. There are increasing fears in some quarters that a sustained rise in demand from Asia may risk more rapid depletion of diamond reserves globally.  In the 1980s, reserves in the ground were thought to represent around 85 years of production. That has now fallen dramatically to an estimated 20 years. Given this, it makes sense at the company level to reduce output.

Analysts believe that the latest measures may drive prices up by an estimated 5% per annum for several consecutive years.

Rough versus polished - a risky strategyThis strategy is not without its risks. If final retail demand remains weak, subject to the uncertainty inherent in the economic cycle, the diamond pipeline - already highly leveraged - may bear the brunt of the squeeze.  Under such a scenario, prices for rough diamonds would increase, driven by reduced output.  Producers of polished diamonds would have little other choice than to accept these higher prices. But a growing imbalance between rough and polished prices may result in more - not less - volatility in the diamond pipeline, exacerbating uncertainty. Botswana's cost-benefit trade-off, and the implications for FX policy For Botswana, the trade-off will depend on the extent of production cutbacks versus any boost to diamond prices.

Given plans for the continued extension of the Jwaneng mine, aimed at securing 95mn additional carats and extending the mine's life for an additional 15 years, it looks at first glance as though the country will come out ahead. Minimal production cutbacks in the context of higher prices would represent a win-win scenario.  For FX policy, improved export earnings reduce the likelihood of the adoption of a faster rate of crawl in the Botswana pula (BWP) against the basket of currencies against which it trades. In other words, there would be less urgency to allow the BWP to depreciate faster in July, when the rate of crawl is typically reset.  But much will depend on how quickly the country's exports recover. Continued ZAR strength with a fiscal deficit already in double digits leaves Botswana with little room to manoeuvre.