Now, with the government reinstating a two per cent Customs duty on import of polished in mid-January 2012, the obvious question is – has the wheel turned full circle?
On the surface it may be seen as a return to the days of a controlled regime. But a more careful analysis indicates that the move is aimed at curbing a rather dubious practice indulged in by a small section – circular trading or round tripping, through which cheap export credit is raised by continuous export-import-export of the same parcel.
Stephen Rego unravels the story of why a duty that was first abolished had to be re-imposed, and talks to leading members of the trade to understand its implication for the Indian diamond industry.
A little over a decade ago, the US, the world’s largest consumer of diamond jewellery was also the single largest export destination for cut and polished diamonds from India. In 2000-01, as much as US$ 2,144 mn of the total of US$ 6,186 mn of polished exported from the country went to the US market, accounting for a share of about one-third of total exports. By 2010-11, at just over US$ 3 bn, the US share had fallen to a mere 11 percent.
Today, it is Dubai that has emerged as the main destination for polished from India. In 2000-01, the Middle East centre accounted for polished worth US$ 258 mn, a share of less than five per cent of total Indian exports. The figure shot up to over US$ 3 billion in 2007-08 and touched US$ 4.5 billion in 2008-09. By 2010-11, the same destination was not just the largest centre for Indian polished, it accounted for a whopping 47 per cent of the total exports of diamonds, or over US$ 12 bn worth of polished.
Even allowing for a significant increase due to the emergence of the Middle East region as a large diamond consuming market and the rise of Dubai as an important trading hub, there was definitely something extraordinary about this phenomenal rise.
Rise of Polished Imports
Though not exactly parallel to this,another notable trend that emerges is the steady increase in the value of polished imports. From a level of US$ 5460.61 mn in 2007-08, the figure moved to US$ 8883.06 mn in 2008-09, US$ 11609.63 mn in 2009-10 and a massive US$ 20774.38 mn in 2010-11. Once again, taken at face value, this may appear to reflect the significant growth in the consumption of diamonds in the domestic market and a rise in the volume of trading taking place within the country.
The reality however, is a bit more complex, and begins to emerge if one shifts focus from gross to net exports. While gross exports of polished were US$ 14605.27 mn in 2008-09, they rose to 18237.56 mn in 2009-10, and zoomed to US$ 28251.92 mn in 2010-11, net figures were substantially lower at US$ 5722.21 mn, US$ 6627.93 mn and US$ 7477.54 mn, during the same period. It should be clarified that the entire value of polished imports cannot be attributed to dubious deals, since goods do move back and forth even during normal trading. Nevertheless, the huge gap between gross and net exports is certainly not a ‘normal’ phenomenon!
The take-off point for this new trend can, in fact, be easily traced to May 2007 when the Indian government abolished the then prevailing three per cent duty on the import of polished diamonds. This was in reaction to a constant demand from industry bodies ever since the late 1990s when the country emerged as the unchallenged leader in diamond manufacturing, and set itself a target of developing into a trading centre as well. The government had been liberalising the trade in diamonds for over a decade prior to that, granting exporters various concessions, and abolishing duty on import of rough in 2002. The May 2007 order of zero import on polished was seen as the final frontier being scaled.
Exploiting the Loopholes
Things however, turned out quite differently. Picking on a window that the policy ad opened, a few companies, many of them newer entrants to the business, exploited the loophole to raise funds through cheap export credit by exporting, importing and cyclically re-exporting the same parcel of polished. This circular trading, or round tripping, gathered momentum over the next few years, resulting in significant distortions in India’s import-export figures.
Alarm bells began ringing among various sections of the trade as the industry emerged out of the 2008-09 crisis, and during a presentation made at the GJEPC’s International Diamond Conference, Mines to Market 2010, Rusell Mehta, COO, Rosy Blue drew attention to the “divergence between gross and net exports”, which, he emphasised, “could not be explained by trading alone.”
Mehta’s candid observation became the focal point of the panel discussion that followed on “Crucial Challenges to Moving Ahead”. The panelists unanimously agreed that the export figures for polished diamonds was not a real reflection of actual manufacturing and exports, and argued in favour of transparency, self-discipline and some informed government intervention.
“There is lack of believability in our numbers. There is an inherent sense that in this industry, people are doing things that might not quite be right,” Rohan Shah, a panelist and managing partner at Economics Law Practice, a Mumbai-based law firm specialising in international trade law had said. By this time, banks financing the diamond trade had also begun to get nervous, particularly after having to deal with a few cases of bankruptcies and some loans being converted into Non Performing Assets.
At the same conference, A P Verma, deputy managing director, State Bank of India, even raised questions about some of the practices adopted by sections of the Indian industry and called on the diamantaires to be more transparent and open in their transactions with the banks. He offered support to the industry but called for reciprocal action from the other side as well.
While some types of gray transactions may have declined as a result, the practice of round tripping continued. Between April-December 2011, gross polished exports stood at US$ 17915.36 mn, while polished imports continued to be high at US$ 12053.82 mn.
There is a broad consensus among all the players that the industry at large is clearly not involved. Industry analyst Chaim Evan Zohar, moderator of the aforementioned panel discussion at the Mines to Market conference is reported to have attributed the “malfeasance to ‘only a very small group of players, who are playing it very big’”.
But, while the number of companies said to be involved may have been small, they have hurt the credibility of the trade, affected the net value addition and impacted foreign exchange contributed by the industry to the exchequer.
The result – tighter lending by banks that is seriously hurting medium and small manufacturers and genuine traders in the industry, and in a ripple effect, impacting manufacturing activity in enters like Surat, acerbating the problem of migration of skilled workers to other more stable, even if less lucrative industries that occurred during the recession of 2008-09.
Finally, the government had to step in, with a harsher measure – the two per cent duty on import of cut and polished diamonds, which it is hoped, will make round tripping less attractive.
Bitter Medicine
The return of a duty whose abolition it had campaigned for less than five years ago, could hardly have been good news for the industry. However, the ill-effects of
dubious trading practices have been so severe that most members of the industry feel that the duty hike will have an overall positive fall out.
Sanjay Kothari, vice-chairman, GJEPC says that the genuine manufacturers have welcomed the government’s initiative. “It is good for the industry if it can succeed in curbing the practice of round tripping which has had a negative impact on our reputation, and creates confusion about the actual levels of manufacturing that are taking place.”
Pointing out that the contribution the industry has made over the years to the country’s exchequer has been a matter of pride, Kothari further avers that round tripping was “a drain on the country’s foreign exchange reserves.”
Anup Zaveri of Polar Star and Convener, Diamond Panel Committee, GJEPC, too believes that the step is not just inevitable, but is good for large segments of the trade. “Manufacturing is India’s strength, something that we have established over the decades,” he says.
“While we are all keen to see the country also develop its trading activity, this cannot be done by putting our manufacturing at risk,” he adds. “And that is what a few elements were doing by using diamonds as a vehicle to generate cheap finance through inter-trade arbitrages, circular trading and other non-manufacturing related activity.”
“The artificial inflating of figures has also led to a price bubble,” Zaveri continues, “and after consumers displayed resistance, and the domestic market slowed down, prices began to decline. Many manufacturers were thus left with high inventories at wrong price levels and this put many genuine companies at risk.”
Zaveri feels that the inflated figures also worked to the advantage of the large mining companies who could use the ‘demand’ to justify higher rough prices. “It became inevitable for the government to act,” he says, “and it is a move that will benefit genuine manufacturer exporters.”
On the other hand, Russell Mehta, COO, Rosy Blue, while agreeing that circular trading had reached levels where the government was forced to act, is of the opinion that the reimposition of import duty on cut and polished diamonds is a “bitter medicine”.
“I don’t like the new duty structure, because it means we have taken a step back,” he says, but quickly qualifies the statement by adding, “But in the end, I guess it had to happen. Some harsh treatment is needed when you are threatened by a serious illness like cancer.”
Mehta also believes that this is not an instant cure. “In the short run it may not make a big difference, and some of those caught in a financial trap do not have an alternative and may decide to absorb the extra burden of the duty,” he says “But, it will be a disincentive, and the effects will probably begin to be seen in the longer run.”
Potential Impact
For the jewellery export industry, which historically emerged when diamantaires began the process of forward integration, there will be no major problem. Most of them are based in the Special Economic Zones where Indian tariffs do not apply. Other exporters too source polished locally, or re-export imported stones after transforming them into studded jewellery.
A duty hike on diamonds would normally hit jewellery manufacturers in the domestic market, but in this case, the trade believes it will not have any significant effect.
“A two per cent duty increase on the price of diamonds will not have a major impact on prices,” says Ashok Minawala, founder chairman, All India Gems & Jewellery Trade Federation (GJF), the apex body of the Indian domestic jewellery industry. “Indian consumers in general have adjusted to such increases after a point of time, though in some parts of the country, the spike in retail diamond prices and the cost of gold, has led to a decline in demand.”
The Gems & Jewellery Committee of Federation of Indian Chambers of Commerce & Industry (FICCI), in a statement, also noted that manufacturers and retailers across the country do not expect their business to be impacted by the recent increase in duty on gold, silver, platinum and diamonds.
“We are the largest manufacturer of polished, cutting 14 out of every 15 diamonds in the world,” explains Zaveri. “So there will be no impact of the hike domestically, as an overwhelmingly large number of diamonds bought by Indian consumers will come from manufacturers within the country and the rough that they import is duty free.”
Minawala, however points out that the imposition of the duty is against the policies of opening out of the market that the government has followed all these years. “In that sense we do not support this measure. We will be discussing the matter, and decide how to take it up with the government,” he states.
How will the duty impact India’s vision of emerging as a trading centre?
“Yes, we are keen to emerge as a trading centre,” says Zaveri, “but not at the cost of manufacturing, which is our essential strength. We must be able to add trading volumes to our business in addition to maintaining, if not growing our manufacturing share. And what was happening was not the sort of trading that we would like to see.”
Another diamantaire, who requested anonymity, said that there are certain negative side effects that the rest of the industry will
Mehta feels that it is not only going to act as a disincentive to others who wish to trade in polished, but will also hit genuine globalised players whose business model may encompass multiple manufacturing units in different parts of the globe. “Now that a percentage of rough sales have been linked to local beneficiation, large diamantaires have set up plants in Botswana, Namibia or South Africa, but ship the polished to India for sorting, aggregation and a centralised marketing,” he says.
The two per cent duty will place an added burden on them. “Either we would have to pay the duty, or incur added costs on setting up a separate marketing mechanism for these goods. This would only add to the processing costs which are already higher in African centres,” Mehta says.
He also draws attention to other business avenues that are likely to be hit. “Large companies may also buy some lots of polished at international auctions that are being held by a few companies. Similarly, we have been doing some bit of service business – assorting goods for particular clients that have been sourced from various places. Now these goods can only come into India after paying duty.”
“In the long run, the duty is not good for our businesses,” Mehta concludes.
Other Solutions
Was there an alternative? Across the board, all the diamantaires we spoke to mentioned the Presumptive Tax regime that the industry had proposed along with its demand for the abolition of duty. “That was the real solution,” notes one industry
member, “because it would have straightaway meant that those artificially inflating their turnover would also be paying more taxes to the government.”
Zaveri and Mehta both believe that the Benign Tax regime that the government had proposed in 2007 was non-workable because it was linked to an artificially high profit level. “Manufacturer margins have been badly squeezed in the last few years, and none of the companies had profits at the levels that were fixed by the government,” says Zaveri.
Others believe that an opt-in clause in any form of taxation regime would leave a loophole that could be exploited.
Mehta says that bodies like the GJEPC have to draw up a blueprint with some creative suggestions for clauses that can protect the interests of genuine players while curbing misuse. “We all have to give it some thought – it could be in the form of a duty drawback when the goods are exported within a given time. Or goods could be received on consignment for aggregation and sorting, and so on. There could be many other measures as well.”
In the longer run, however, these should only be stopgap steps. “We live in a globalised world,” Mehta says, “and I am hopeful that sooner rather than later we will be able to go back to the zero duty regime.”
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