Funny Money

Financial turmoil in the international economy has finally worked its way into the important U.S. market. The continued decline of the Far East economies and the recent collapse of the Russian Ruble have brought about a sharp decline in the U.S. stock market. The perception that the U.S. market would remain unaffected by a rapidly changing global economy has now been replaced with an increasing awareness that the international equity markets are highly interrelated. There is concern that increasing stock market volatility will have a negative impact on consumer confidence and may hurt diamond demand as our industry heads into the important holiday season.

While Monday’s 512 point plunge of the Dow Jones Industrial Average represented a relatively small 6.37 percent “correction” and Tuesday’s rebound brought the market back up 349 points, the market’s increasing volatility provided a wake up call for millions of consumers who are invested in the U.S. market.

Over the past few years, the strong appreciation of the U.S. stock market attracted an increasingly broad range of small investors who believed the market provided a relatively safe way for them to increase their personal wealth. Stock ownership in the U.S. is highly diversified with about 40 percent of consumers holding positions in the equity markets. These days almost all wealthy consumers are also investors and changes in the financial markets can be expected to impact consumer behavior.

While industry concern about the current global economic environment is highly justified, it is important to develop a reasonable perspective of how developments in the financial markets are likely to impact the diamond industry. Given the increasingly complex and volatile nature of the financial markets we must take care not to overemphasize the impact of short-term volatile moves such as this week’s U.S. stock market decline. Just because the stock market goes down one week does not mean it will not go up the next.

The real challenge is to extend our analysis beyond the impact of short-term market fluctuations so as to gain an understanding of the primary economic forces that are shaking up the international financial markets. The fact that the financial markets are in turmoil is interesting and important, but far more important are the reasons why these markets are changing and where these changes will lead. Recent shifts in the financial markets are only the first stage of a development process that will realign the global economy. A new world order is evolving as entire regions of the globe adjust to new economic realities. The sharp decline of Far Eastern currencies and stock markets, the collapse of the Ruble and economic chaos in Russia, and this week’s plunge of the U.S. stock market are not isolated independent events. There is an important story here. The markets are talking to us, trying to tell us something about the future.

The key to understanding the global economy lies in a careful analysis of the primary role foreign currency rates play in regulating the international market place. Simply put, foreign currency rates are the be-all and do-all of the global economy. They are more important than anything else and included within them are an infinite number of economic factors that influence the global economy.

The wealth of a nation in relation to other nations is defined by the country’s foreign currency exchange rate. If a country’s foreign currency rate improves, it has more wealth and import purchasing power in the global economy. If the currency rate declines, then the country is poorer and has less import purchasing power in the global economy.

We must also understand that a country’s ability to export products is directly tied to its foreign currency rate. Exports from countries with strong currencies are more expensive than exports from countries with weak currencies. Therefore, countries with weak money can produce more locally and sell more internationally.

Finally, foreign currency rates directly impact the value of foreign investments in a country. Newly developing countries require a relatively high level of foreign investment capital to establish and maintain production facilities suitable for the expansion of their international trade. In the past decade, developing countries established local currency stock markets to support the expansion of local firms. These stock markets are highly sensitive to foreign currency fluctuations. While increasing foreign currency rates attract new investment capital, sudden downturns in foreign currency rates collapse these stock exchanges as foreign investors dump shares to avoid foreign currency losses.

Foreign currency rates therefore control how much a country can buy or sell from the rest of the world. The international wealth of a country, and the level of foreign investment is directly related to the currency rate. In summary, the financial well being of a developing country is highly sensitive to shifts in its foreign currency rate which has a strong “macroeconomic effect” on the local economy. For export-based developing countries, the foreign currency rate is the ultimate regulator of the local economy.

In the “good old days” before globalization when countries did not do “too much” importing, exporting or foreign investing, local economies were not very sensitive to currency rates. Often a country could control its foreign currency rate because it was not overly dependent on international trade. However, over the past few decades all the developing countries internationalized their economies. Foreign trade and investment became national priorities as countries realized real growth through international expansion. Today the global economy is such that few, if any, national economies could exist without regular and consistent foreign investment and trade.

As more and more countries internationalized their economies, the level of economic interdependence increased exponentially. Countries relied on each other not only for trade, but also for investment. Wealthy countries capitalized on the economic expansion of less wealthy countries. This enabled the expansion of local production facilities and international trade. The system literally fed off of itself as increasing exports and resultant foreign currency reserves boosted local currencies which then encouraged additional investment. The cycle of interdependence brought about a never-ending cornucopia of economic benefits to the global economy. Everyone did well.

The new improved, highly interdependent global economy also brought higher risks. Countries can no longer control their currencies or limit their role in the global economy. Problems in one country now spread quickly to other countries. To some degree the global economy is regionalized and some believe that economic problems in one sector of the global economy could be isolated from others. In fact, recent events have shown that all countries share a common market. No one is safe and no one can control the global economy. We now live in a world where the economic policy of most developing countries is designed to react to changes in the global economy. The IMF has become the new global central bank.

Consider how recent developments in the global economy may impact the diamond industry in the near to medium-term future. The collapse of Far East foreign currencies had an obvious direct negative impact on diamond demand due to sharply higher local currency prices. While the “pricing” effect was significant, its impact on diamond demand was secondary to the “macroeconomic effect” of sharply lower foreign currency rates which resulted in the collapse of the local economies. Over the medium-term, Pacific Rim diamond demand is expected to be very weak due to the “negative wealth effect” intensified by the collapse of local stock markets.

Over the long-term, lower foreign currency rates should stimulate increased local production for export. Providing there is no collapse of the global economy and there is suitable foreign demand for locally produced products, the Far East economies should be able to export their way out of the current recession over the next three years. The extremely high savings rate in Japan and the developing potential of China’s consumer market will also fuel the next economic expansion cycle in the Far East region. This economic boom, when it finally comes, will be stronger and longer than anything the diamond industry has ever experienced.

The situation in Russia is extremely troubling from a political and social perspective. From an economic standpoint, Russia’s diamond demand has not been significant enough to impact the market. While the collapse of the Ruble may hurt some large Western European investment firms, Russia’s financial woes are not expected to spread to Europe. Barring the spectacular return of communism it is unlikely that events in Russia will have any direct or secondary impact on diamond demand.

Concerns that Russia may dump diamonds in order to raise vital foreign currency reserves are widespread in the industry. Russia’s agreement with De Beers will probably negate this potentially damaging scenario. While Russia’s stockpile of better quality, larger stones is reportedly depleted, there is probably a very large supply of smaller, less expensive diamonds in its stockpile. There is concern that these diamonds could be dumped onto the Indian market if De Beers does not choose to buy them.

The U.S. has been a fantastic market for diamonds over the past few years. As our graphs and charts on this page and page 11 indicate, U.S. polished imports grew 28 percent in 1997 and 23 percent for the first half of 1998. The strength of the U.S. market greatly helped the industry compensate for sharply lower demand from the Far East market during the past few years.

While the trade is maintaining expectations for a strong holiday season in spite of this week’s stock market correction, there are increasing concerns that the U.S. market may have peaked. In general, market conditions are reasonable, but not great. Currently, U.S. retail demand is steady but dealers are reporting extremely quiet market conditions and a hesitancy by retailers to stock up on diamonds. Liquidity in the market is also a problem as more and more retailers rely on memo programs and long-term credit sales. The cash market for diamonds in the U.S. is practically nonexistent.

To some degree, the conservative attitude prevalent in the diamond industry reflects the overall mood in the U.S. Everyone, from leading economists to consumers, is wondering how long the current economic good times will continue. No one is expecting a sharp immediate decline but everyone seems to be anticipating some kind of slowdown. There is no longer a party atmosphere in the air. One is reminded of the Yiddish saying “Kan Boim Vaxt Nich Biz Dir Himmel – No tree grows to the heaven.”

Perhaps industry concern about the U.S. market is a direct result of the fact that the U.S. is the only real viable market today. Diamond dealers are afraid to say it. But everyone is deeply concerned about the future of the industry. What if the U.S. market slows down significantly before the Far East comes back on-line? What will happen to the diamond industry? The simple fact that the U.S. market is the only game in town is creating increasing concern about its well being.

This week’s stock market “correction” did not do anyone any good. Leading economists are interpreting the correction as a sign that the stock market boom may be over. Consumers are waking up to the fact that the stock market is no longer a sure bet, and confidence in the future has been rattled. While almost everyone agrees that this week’s stock market gyrations will have very limited impact on consumer holiday demand, consumers and the trade are concerned that there may be further corrections.

Frankly, from an objective economic standpoint, the U.S. economy is looking great. Employment is up and disposable income is also up. All of the basic economic factors are positive. In essence the problem is not the economy, but how people are thinking about the economy. The greatest challenge facing the U.S. economy right now is psychological.

In spite of the concerns mentioned above, there are several reasons to believe that the U.S. economy will continue to expand well into 1999. As we explained, a country’s exchange rate is the key economic factor influencing its wealth and position in the global economy. What about the U.S. exchange rate?

The U.S. dollar is America’s ace in the hole. The internationalization of the global economy has created a situation whereby the U.S. dollar has become the currency of first and last resort. Every country measures the value of its currency in dollars. Foreign firms and individuals that wish to secure their financial position convert their local currencies into dollars. Given the increasing level of uncertainty in the world, it appears increasingly likely that there will be a very strong demand for dollars and a large amount of dollars in the hands of investors.

There are basically two things investors can do with dollars. Buy U.S. dollar bonds, or invest in the U.S. stock market. Either way the U.S. economy benefits. If bonds are bought U.S. interest rates remain low which encourages economic expansion. If dollars are invested in the U.S. stock market, stock prices do well and this restores consumer confidence.

In spite of all of the difficulties in the world, there is reason to believe that the U.S. economy will continue to do well through the coming holiday season and into the next year. While the latest stock market correction should serve as a warning that the U.S. expansion will not continue indefinitely, and that our industry must be prepared for the inevitable U.S. slowdown, it appears likely that the current instability in the global economy will help rather than hurt the U.S. economy.

In essence, the U.S. dollar is a very funny type of money. To most U.S. citizens it is simply the way to buy and sell things. However, for the rest of the world the U.S. dollar is the ultimate store of value. You don’t just use dollars to buy things you hold them so that you will be able to buy things in the future. Wouldn’t it be nice if diamonds could do the same thing?