the world runs out of diamonds¬ Output curbs by De Beers are likely to be a game-changer
¬ Growing imbalance between rough and polished prices is a concern
¬ Benefits would reduce risk of an FX adjustment, but ZAR strength a concern
Global trade has bounced back faster than in previous crises
For many African commodity producers, the recovery in China’s demandfor commodities, particularly metals, has been a key driver of improvedprospects. For the continent’s diamond producers, still dependent onWestern markets for over 50 percent of final retail demand, the outlookhas been less certain.
Although sales have recovered from the lows of the crisis, there islittle reassurance on the sustainability of demand. The diamondpipeline remains notoriously dependent on the availability offinancing, but it is unclear whether an improvement in financing(perhaps subject to new reversals in the short term) or a moresustained turnaround in underlying demand has driven the recent pick-upin sales.
Last year, Botswana’s economy experienced one of themost severe economic contractions in Africa, declining by six percent.Given the weak base, a rebound in 2010 – with diamond exports havingresumed – is a given. But with the country in its second consecutiveyear of a double-digit fiscal deficit, having already had its prizedsingle-A rating downgraded by S&P, it is not just the near-termoutlook that matters. Having realised the downside of over-dependenceon a single commodity, Botswana has focused its efforts on spending inorder to diversify future export revenues. Ironically, the outlook fordiamond earnings remains key to the affordability of thisdiversification strategy.
De Beers output cut expected to shore up diamond prices
Recentnews may be encouraging. Following the crisis-related slowdown, thediamond market saw better-than-expected seasonal sales aroundChristmas. Continued restocking by retailers underscored demand inQ1-2010, and Botswana’s exports are back – if not exactly to cyclepeaks, then at least to levels much higher than those seen at the lowpoint of the crisis, when Botswana’s mines were forced to shut down forfour months (Chart 1). Press releases have touted the expected doublingof China’s share of the world diamond market to 16 percent. But thereal game-changer for Botswana’s export outlook may be the recentunveiling of plans by De Beers to curb output. The company, which has along standing partnership with the Botswana Government (which, in turn,has a 15 percent equity stake in De Beers), is thought to controlaround 40 percent of the global rough diamond market. Officially, thereason for the production cuts was asset sales by De Beers during therecent crisis, which may necessitate reduced output levels. Outputrationing will help to reduce running costs amid a hoped-for turnaroundin financial strength indicators.
Even diamond reserves may not be forever
But other factors may also lie behind the planned cutbacks. Thereare increasing fears in some quarters that a sustained rise in demandfrom Asia may risk more rapid depletion of diamond reserves globally.In the 1980s, reserves in the ground were thought to represent around85 years of production. That has now fallen dramatically to anestimated 20 years. Given this, it makes sense at the company level toreduce output. Analysts believe that the latest measures may driveprices up by an estimated five percent per annum for severalconsecutive years.
Rough versus polished – a risky strategy
This strategy is not without its risks. If final retail demandremains weak, subject to the uncertainty inherent in the economiccycle, the diamond pipeline – already highly leveraged – may bear thebrunt of the squeeze. Under such a scenario, prices for rough diamondswould increase, driven by reduced output. Producers of polisheddiamonds would have little other choice than to accept these higherprices. But a growing imbalance between rough and polished prices mayresult 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 productioncutbacks versus any boost to diamond prices. Given plans for thecontinued extension of the Jwaneng mine, aimed at securing 95mnadditional carats and extending the mine’s life for an additional 15years, it looks at first glance as though the country will come outahead. Minimal production cutbacks in the context of higher priceswould represent a win-win scenario. For FX policy, improved exportearnings reduce the likelihood of the adoption of a faster rate ofcrawl in the Pula against the basket of currencies against which ittrades. In other words, there would be less urgency to allow the Pulato depreciate faster in July, when the rate of crawl is typicallyreset. But much will depend on how quickly the country’s exportsrecover. Continued Rand strength with a fiscal deficit already indouble digits leaves Botswana with little room to manoeuvre.
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