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22 Oct 2008 - 12:00

The diamond industry’s lexicon has dramatically changed during the past few years. Domestic beneficiation, added-value creation, and downstream developments in the producer countries are now the buzz words dominating the African producing countries. These words have also, albeit reluctantly and belatedly, been embraced by De Beers as a basis for its rough allocation policies. In contrast, the world’s second major producer, the Russian Federation, has gone amazingly silent on the subject. Russia’s former president and now prime minister, Vladimir Putin, has made it clear that he wants the federal government to absolutely control the Alrosa mining conglomerate – the position of government on beneficiation (manufacturing) seems unclear or, more correctly, ambiguous.

 While African presidents, ministers and producers seek every possible public forum to espouse the perceived endless virtues of beneficiation, Alrosa’s enigmatic president, Sergei Alexandrovich Vybornov, doesn’t seem to miss an opportunity to express his wholehearted opposition to domestic beneficiation in the Russian Federation.

 Ostensibly, the opposition is based on strong economic convictions – the return on capital invested in diamond cutting is too low to be of interest. Or, it may well be based on a narrower Alrosa objective; the views espoused may not necessarily represent those of government. It is clear that Vybornov doesn’t like pressures to accommodate the domestic manufacturing sector by subsidizing rough allocations – something that was the case until a few years ago. It might happen again.

Regarding the view on low return of capital, we can only say: “Welcome to the club, Mr. Vybornov. You have astutely identified a global predicament facing diamond manufacturers who represent a highly undesired (and ultimately unsustainable) situation.” This is a condition, I would add in marketing jargon, “largely brought about by our favorite producers.” But let’s leave that aside for the moment.

Manufacturers are engaged in diamond manufacturing in locations where (1) either the activity makes the most economic sense; or (2) governments induce manufacturers to cut and polish in their territories. Though it all falls under the common denominator of beneficiation, the economic rationale in the latter case is affected by governmental policies. In many a country, a reduced economic rationale was or is complemented by subsidies, preferred access to rough or rough export taxes.

The truth is that some of the world’s greatest success stories in beneficiation can be found in the Russian Federation and, especially, in its main manufacturing center, the city of Smolensk. A back-of-the-envelope calculation shows that in 2007, some 50 Russian manufacturers produced some $1.2 billion worth of polished. Out of a total of 8,000 production workers throughout the Russian Federation (including Yakutia), some 3,500 are employed by some seven factories in Smolensk. Half of the Russian polished output comes from Smolensk, which has a well-developed support infrastructure of banks, diamond cutting training schools, tool manufacturers and suppliers, gemological research institutes, and grading labs, to mention but a few of the required attributes of a well-developed cutting center.

The largest manufacturer is the Kristall Production Corporation. If we go back to the beneficiation jargon, Kristall Smolensk is, by my reckoning, the world’s oldest and largest manufacturer in any producer country. It is now modestly celebrating 45 years of continuous operations. In 2007, Kristall Smolensk produced some $404 million of polished – almost the amount the 16 factories in Botswana hope to be jointly producing in a few years time.

Governmental Support for Kristall

In the former Soviet Union, the polishing industry was traditionally state-controlled. I recall that back in 1990, on the eve of the breakdown of the communist system, the Kristall factories were the manufacturing arm of the government-owned Glavalmazzoloto (a precursor to Alrosa). At that time, domestic output was about 1.5 million carats of mostly smalls or melee polished worth about $600 million. The industry then was famous for its make (the quality of the cut) because of the total disregard of the optimization of manufacturing yield and the desire to deliver manufacturing quotas of goods characterized by perfect proportions.

In those years, observers claimed that Russia would get more foreign currency for exporting rough than for selling the resultant polished, something which might have been inherent to the non-market economic system. That never was a fair argument. One certainly could also argue that much or all of the diamond mining activities lacked sound economic basis.

What is clear is that Premier Nikita Khrushchev, while speaking at the 22nd Congress of the Communist Party of the Soviet Union in 1961, demanded the stepped-up development of diamond mining and manufacturing mostly for purely strategic and security reasons. After World War II there was a great demand for natural industrial diamonds, and there was a Western boycott in place denying access to those goods to the Soviets. Economic considerations were not a factor then. Pleasing and satisfying the luxury needs for Western women was the least of Khrushchev’s concerns: he needed the industrial diamonds that De Beers refused to supply. Manufacturing gem-quality goods was a “by-product” – something that was beneficial to the regional economies.

Consequently, although diamonds were mined in Yakutia, Smolensk was singled out as the preferred city to establish diamond manufacturing. This had a reason. Smolensk, located on the Dniper River some 360 kilometers west/southwest of Moscow, is one of Russia’s oldest cities founded almost 2,000 years ago. The walled city was destroyed several times throughout its long history. It found itself on the invasion routes of both Napoleon and Hitler. Indeed, in Russian history, the Battle of Smolensk, which was launched in 1941, was the first Soviet counteroffensive against the German army; it resulted in 93 percent of the city being destroyed.

The government of the Soviet Union wanted to rebuild and restore Smolensk’s former glories and intentionally directed diamond manufacturing to that city. It was interested in creating employment and bringing other economic benefits to the area. Today, we would call it a policy of beneficiation aimed at providing skills – and hope – to the people who were rebuilding their ruined cities.

In 1963, the Kristall Production Company was established alongside half a dozen other state-owned diamond plants in the Ukraine, Belorussia, Armenia and Moscow proper. One of the early managers of Kristall Smolensk was Alexander Shkadov, who was not just the leading diamond manufacturer but a progressive community leader and a driving force in regional politics. In 1998, he was shot and killed by political rivals.

This year, Kristall Smolensk, the largest diamond manufacturer in Russia, is celebrating its 45th year of continued production. Managed by Maxim A. Shkadov, the son of Alexander, the company employs some 2,500 cutters (out of a total diamond employment of 3,500 in Smolensk). Kristall Smolensk produces over $400 million worth of polished per year, which is well over one-third of Russia’s total polished production. While other Kristall factories either went bankrupt or were privatized, Kristall Smolensk remained fully government-owned.

In a way, Kristall Smolensk management is faced by a modern version of “Mission Impossible”: on the one hand, it must show that it can compete competitively in the international manufacturing sector, while, on the other hand, it is still adhering to a “beneficiation model,” where contribution to the local welfare clearly remains a cornerstone in management strategies. Is that a sustainable model? The answer must come from government.

Though Kristall Smolensk is a DTC Sightholder most of its rough comes from Alrosa. The last few months, Alrosa has become the highest-priced rough producer in the market. Only a few weeks ago, DTC Managing Director Varda Shine left a $50 million rough allocation on Alrosa’s tables because the price was too high, at least in her view. The Kristall Smolensk people tell me that they can buy rough at five to six percent cheaper in Antwerp than they get it from Alrosa. At the end of the day, both Alrosa and Kristall Smolensk are government-owned. The situation simply seems to reflect an incongruity of policies, which is not unusual – not just in Russia but in other producing countries as well.

Unquestionably, Kristall Smolensk is truly the oldest manufacturing plant in continuous operation in probably any of the world’s diamond-producing countries. Under the management of Maxim Shkadov Kristall has become very efficient. It employs all of the latest Sarin and other cutting technologies. The quality of Kristall Smolensk’s manufacturing output is truly amazing. It has developed various brands and is producing the Dubai Cut, among others. Its Hearts and Arrows goods are simply breathtaking.

This is not the time to discuss Kristall Smolensk but rather to highlight the lack of Russian government guidance on beneficiation. The chairman of the board of Kristall Smolensk, Vladimir Rybkin, is the head of Russia’s Gokhran – a body controlled by the finance ministry. Alrosa’s Vybornov is also on Kristall Smolensk’s board as are several representatives of the Federal Agency for Managing Federal Assets. An important member of Kristall Smolensk’s board is Victor Nikolayevich Maslov, the governor of the Smolensk region.

What do the regional and federal governments want? Social and economic benefits to the region or the highest return on capital expressed in dividends to the state? Some argue that even a state company needs to satisfy the state by producing dividend checks. Others argue differently. And this makes the case of Kristall Smolensk so intriguing – because management is merely implementing the policies set by the board.

The support of social infrastructure in society (whether medical clinics, kindergartens, schools, etc.) are policies determined by the board. Kristall Smolensk is a profitable company. On the balance sheet, the company seems to do slightly better than breaking even, which is mostly attributed to a combination of the social and economic obligations to the community and the high cost of rough supply.

As previously alluded to, Alrosa, the company’s rough supplier, seems to move in different directions than De Beers. As was also illustrated in last week’s column on Botswana’s and De Beers’ opposition to beneficiation in Botswana just a decade ago, it was Alrosa that, in 1998, expressed great support for beneficiation. The company’s perennial and eloquent vice president, Sergei Oulin, said at a 1998 conference: “Alrosa pursues a policy aimed at supporting the domestic diamond cutting industry by supplying stable amounts and assortments of diamonds. Special terms and conditions are provided for state-owned cutting enterprises on the basis of bilateral cooperation agreements.”

Stressing the worldwide leadership role of Alrosa, the company spokesman stressed the virtues of its highly developed diamond processing sector and significant capacity of diamond cutting enterprises, its high export potential of the domestic diamond industry (about $1.5 to 2.5 billion annually), and the availability of skilled personnel and training systems.

A decade ago, Russia was responsible for 8 percent of the worldwide diamond manufacturing output. This has now declined to some 6.5 percent. Mostly thanks to Kristall Smolensk and to manufacturers in Yakutia, Moscow and a few other places, Russia is still a formidable factor in the polished markets. Whether the industry will grow will mostly depend on the policies, directions, and leadership of the federal government, the Yakutian government and Alrosa.

One may laud the virtues of a freely and fiercely competitive market, but in truth, at the end of the day, the Russian diamond manufacturing sector is not all that different from those in the African producing countries. Maxim Shkadov and his colleagues at Kristall Smolensk deserve to be congratulated on their achievement and their skills in running a state-owned plant in a competitive market. They may discover, however, that their very own future may not be in their own hands.

KRISTALL SMOLENSK – A SPARKLING CASE FOR RUSSIAN BENEFICIATION 11 September 2008 CHAIM EVEN-ZOHAR

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