INDIA’S IMPORT DUTY EXEMPTION: CURSE OR BLESSING?

(This article was published in Israel): The Indian diamond industry is, in a strange way, enjoying a period of exceptional goodwill in the highest echelons of governance. There is a tremendous behind-the-scenes willingness to assist the industry in the development of relations with African producer countries and Russia. But the government is forthcoming at home. Just look at the Indian government’s agreement to impose a “presumptive tax system” (i.e. an agreed profit level on turnover, which is comparable to the tax systems enjoyed by the industry in Israel and Belgium) and the removal of all import taxes on polished diamonds.

What may not be sufficiently appreciated is that it takes two to tango. If the industry doesn’t do its part, the current goodwill may quickly evaporate. Not everybody in India’s government is enthusiastic about assisting the diamond industry and meeting its requests. Import duties, which have been removed, for example, can also be reinstated. Actually, manufacturers in India had severely protested the removal of these duties (fearing competition with China), and any pretext for pleading for the reimposition of the tax may well be welcomed.

The enormous success of the Indian industry is partly, maybe largely, a result of good cooperation throughout the years. The recent removal of import duties on polished diamonds was an additional step meant to make India a more attractive trading center, to enable foreign buyers to find all their polished requirements in Mumbai.

Sadly, as is often the case, one needs only a handful or so of unscrupulous profiteers to ruin a good thing for everybody. That may be the case now regarding the import duties.

The duties on polished imports were dropped from five percent to zero in May 2007. Because of the sky-rocketing activities in the four-month period preceding and following the announcement, Indian traders imported $1.41 billion worth of polished, mostly into Surat. As the system needed a “warming up,” the activity developed in earnest in July, when polished diamond imports reached nearly $0.5 billion. ($482 million, to be precise.)

These imports largely represent a “circular” trade (in-out, in-out), mostly with Dubai. One might argue that this is nothing new. But hitherto “circular” trade involved combined rough and polished transactions, balancing rough imports with (overstated) polished exports, etc. What is different now is that the free imports of polished have made it much easier to achieve greater exports and, consequently, more access to cheaper financing.

Needless to say that these newly developed manipulations are also reflected in India’s diamond export figures: in these four months (April-July), India’s polished exports soared to 12.9 million carats worth $4.07 billion – a 25 percent increase over the comparable period last year. The polished manipulations were clearly evident in July, when total polished diamond exports registered a growth of 50 percent over the same months last year!

The Nature of the Circular Trade

In all fairness, part of the polished imports is quite legitimate. The zero duty enabled many Indian diamantaires to bring home some of their own stocks held in overseas inventories, especially appealing to do when there is an active and attractive local market for the goods.

Surat is the preferred location for imports. In the Mumbai trading hub, there is a two percent tax (octroi) on all imports from other Indian states if the diamonds are sold for consumption within Mumbai limits. A tax exemption is possible when a guarantee of re-export is given.

It is therefore prudent tax planning that many of the imports go to affiliates in Surat, where there is no such a tax.

As in the last fiscal year – when there was still a five percent duty in effect – monthly polished imports averaged $158 million (about the equivalent of 32 percent of July’s imports). It is probably fair to say that about a third of the current imports represent ordinary business serving the domestic trade. Allowing also for natural trade growth and inventory returns, one might conjecture that the “unusual” “circular” trade only applies – so far – to about half of the activity.

How does the “circular” trade operate and what is its purpose to begin with? Certain individuals, or agents,(not necessarily from the diamond business) will import polished diamonds from Dubai for a service fee on behalf of third parties. These fees are as low as 0.1 percent, but, of course, these commissions “add up” to nice income. These agents may themselves pay for these imports at the official exchange rate and then sell the dollar proceeds off on the local black currency market. The differences can be substantial. It’s easy profit.

However, there is a variation on the scheme that is far more prevalent: The agent imports the polished into Surat on behalf of a third party (again, for a service fee) and then sells these goods officially (i.e. invoiced) to that very same party, which will then officially export these goods (to Dubai) and enjoy subsidized (concessionary) export financing.

These funds are put to work in the domestic informal non-bank financing sectors. When the margins on the proper diamond business are minimal or non-existing, it is tempting to earn good money on the grey financial markets. Moreover, a few months down the road, when the export proceeds are officially remitted, there is an added bonus of earning rupees because of the continued appreciation of the exchange rate.

Officials of the Gem and Jewellery Export Council are Concerned

These are very sensitive issues and it is hard to get either official information or comments about them. However, after talking with some members of the board of directors of India’s Gem and Jewellery Export Promotion Council, I am aware that they are privately distraught about these practices and, frankly, they also find it hard to “quantify” the volumes involved.

From the Council’s perspective, everything is proper and legal. All imports are official, the shipments take place through the established courier services, and all subsequent re-exports are also official. Even if the Council may not like some practices, it probably isn’t allowed or capable to intervene.

Of the various leading local manufacturers and exporters with whom I have talked, some confirmed that they “have been approached” by operators suggesting their participation in the “circular” scheme, mainly to get an advantage of exchange rate differentials. One sophisticated trader said, “Chaim, there are some aspects of these transactions I frankly don’t understand. Playing safe is staying away from it all.”

A major player points his finger to the Indian banks. Their eagerness to finance “circular” export trade deals is seen as a disgrace. Bank financing sources aren’t infinite – and proper exporters need to compete with “less proper” exporters for the available borrowed resources.

The irony is that the forthcoming government support in the form of “presumptive taxes” may make it less attractive – or even undesirable – to artificially increase one’s exports.

In a vast industry that employs close to a million people, there will always be some “deviants” whose understanding of “two to tango” is limited to “dirty dancing.” They should be made known that they dance out of sync with the great majority. By taking quick action, the Indian diamond industry might rid itself from the new circular menace before real damage is inflicted.