Are diamonds Russia's best friend?

Russia's diamond stockpile is sucking the country dry. But dumping the stones would be even worse.

By Russell Shor

There is a tale, apocryphal or not, of a 1960s plan by the Soviets to disrupt South Africa's largest diamond firm, De Beers, by manipulating the world diamond market with their own native supply. The plan proceeded apace until someone in the government realized that Soviet diamond mines supplied about a quarter of De Beers's rough diamond sales. Needless to say, if the plan was ever real, it backfired.

Regardless of that story's veracity, one lesson from it is certainly true: Along with oil and natural gas, diamonds are another homegrown commodity that Russia has managed through politics (rather than good business sense) to varying degrees of failure. Most recently, the New York Times reported on May 11 that Russia's diamond mining and marketing arm, Alrosa, began stockpiling rough diamonds with the government instead of selling them into a falling market. So large is the cache -- an estimated 34 million carats of yearly mine production worth some $2.8 billion, or one sixth of the world total -- that "Russia has become the arbiter of global diamond prices," the Times reports.

So what does Russia want with the stones?

First, a bit of history. Beginning in 1959, Russia began selling all of its rough diamonds to De Beers in a not-so-secret arrangement that left a loophole allowing for 20 percent to be cut locally and sold on world markets. That 20 percent proved infinitely elastic over the years (20 percent of a secret quantity is how much?), and there were times during the 1980s and 1990s when Russia was so overzealous that it flooded the market, even to the point of undermining the price for its own stones. If the goal was to control the market, it worked; Russia drove diamond prices straight into the ground.

The economic rationale for hoarding looks, at first glance, to be spot on. As the world economy sank last fall, diamond cutters and dealers were appealing to mining companies to slow or suspend production because their customers were fleeing and banks were pulling out. Two big producers did just that. De Beers mothballed its Botswana mining operations, and Rio Tinto cut its diamond production 40 percent. Alrosa was merely following suit.

But in Russia, diamonds are forever more complicated than that. Unlike De Beers and Rio Tinto, which responded to the slowdown by halting their mining activities, Alrosa's strategy has been to sell the stones to Gokhran, the Russian government's stockpiling agency. True, there is good reason to cut diamond supply and push prices back up. But Russia literally cannot afford to do so for too long. The country's credit rating is faltering, and even at a depressed world market price, a diamond buying spree would cost the government a massive $220 million each month.

Even worse for the Kremlin, there is more than money involved. Sakha republic, the semiautonomous region where the mines are located, has a nearly 50 percent stake in Alrosa, meaning that its government receives that share of the profit from sales to Gokhran. Giving Sakha a boost is the last thing Moscow wants to do. Along with Chechnya and a few other areas, Sakha has a semiautonomous clause in its Constitution that has Moscow perennially worried about secessionist fervor.

In short, Russia's diamonds are being held by a government that can afford neither to sell them nor to buy many more -- particularly if nearly half of Alrosa's proceeds keep going to Sakha.

It's the kind of conundrum that only luck can fix -- and it just might. Diamond cutters, who weren't buying anything in March and April, now say they are back in the market for rough stones of the Russian sort. Shoppers are returning to jewelry stores. Large diamond operations, especially those in India, have cut the padlocks from their compounds and called workers back. Banks are lending again, albeit at reduced levels. On May 12, Alrosa announced an agreement with 15 Antwerp rough-diamond dealers to sell $500 million worth of goods by year's end.

So, if the recovery is for real, the Russian government may profit from its stockpile. If things slide again, the diamond industry has to hope that the Russian government has enough money, and enough trust in Sakha, to keep buying.

Russell Shor is senior industry analyst at the Gemological Institute of America.