In February 2018, India was rocked by news of a massive case of bank fraud, involving some of the country’s wealthiest and most well-connected citizens as well as its third largest bank. The incident, referred to as The Punjab National Bank (PNB) Scam, involved diamond industry billionaires Nirav Modi (no relation to the Indian Prime Minister) and his uncle Mehul Choksi conspiring with PNB officials to obtain fraudulent letters of undertaking from foreign banks to make payments to overseas suppliers. These letters of undertaking, worth $1.8 billion according to Forbes, were essentially promises by PNB to pay foreign banks in case of default by Modi, Choksi, and their associated corporations. Upon discovery of the scam, Modi and Choksi fled the country, leaving PNB to bear the loss.

The PNB scam, in addition to triggering massive public outrage towards the perpetrators, threatens to have detrimental effects on India’s diamond industry. The scam hit especially hard in India, a country with colossal and growing inequality, and high corruption, where the wealthy and well-connected appear to get away with anything while hundreds of millions live in poverty. The political response in India was swift, with every major Indian politician condemning Modi, and calling for him and his uncle’s immediate extradition back to India.

Although the official Indian reaction to the scam has focused on seeking punishment for Modi and his affiliates, the public reaction has generally overlooked the far-reaching pact of the scam on the Indian diamond industry, as well as on Indian industry at large. The scam threatens to gravely damage India’s massive and fast-growing diamond industry with reduced access to vital lines of credit from foreign banks and an industry exodus to countries viewed as having a more ethical business climate. Through these adverse effects, the PNB Scam unveils the problems with the Indian diamond industry, and highlight how India, and emerging markets in general, must stamp out corrupt business practices if they ever hope for local industry to thrive in the global economy and attract foreign investment.

According to The Economic Times, the Indian diamond industry is by far the world’s largest, accounting for 70 to 75 percent of diamond exports in the world and growing at 10 to 15 percent a year. According to the Indian Gem and Jewelry Export Promotion Council, 93 percent of all rough diamonds in the world are polished in India. The industry is a significant sector of the economy in Mumbai, India’s financial capital, and Surat, India’s “diamond city”. Mumbai houses the world’s largest diamond exchange. In Surat, a city of 6 million people, 1 million work in the diamond industry.

The revelation of the PNB scam has exposed the susceptibility of the diamond industry to corruption because of its vulnerability to fraud and opacity. India’s diamond industry is unique in how its structure relies on personal connections and consists mostly of smaller traders. The industry is dominated by businesspeople from the western state of Gujarat, who have historically relied on family and social ties to run diamond businesses. This results in a highly efficient system of vertical integration from mine to showroom. The industry consists of a few behemoth corporations and tens of thousands of smaller traders. Nirav Modi and Mehul Choksi were two of the biggest players in the industry, running two of India’s largest amond corporations, Nirav Modi Haut Diamantaire, and The Gitanjali Group, respectively. The two had largely built their businesses using family connections. The fact that the Indian diamond industry relies on family connections is essential to understanding the story of the PNB Scam because such reliance naturally increases the potential for fraud.

In addition to most diamond businesses in India being run using family connections, another unique feature of the industry is how most transactions are conducted with cash under the table. This is a widespread feature of Indian industry at large. Along with the extensive use of family and social connections, this provides room for unethical business practices and has contributed to the diamond industry in particular earning a dishonest reputation. Furthermore, the industry remains lightly regulated and is widely used for money laundering and tax evasion in India.

The scam’s immediate effects on the diamond industry itself are felt most strongly by the smaller diamond traders in the form of limited access to credit and threatening industry movement. Just months after news of the scam broke, the Indian diamond industry, especially small to medium sized traders, is feeling the ripple effects of the scam in the form of greater difficulty in obtaining credit and through threats of international suppliers shifting operations to countries viewed as having less corrupt business climates. Senior diamond traders in Mumbai and Surat are already reporting banks asking for higher collateral on lines of credit. According to Dinesh Navadiya, past president of Surat Diamond Association, “securing bank loans for small diamond businesses may become very tough. The banks have not been very keen to give loans to small diamond units, and with the Nirav Modi scam, credit line will dry down.” This drying down of credit for smaller operations should be of grave concern to Indian diamond businessmen and policymakers, as the cutting and polishing of smaller diamonds forms the bulk of the industry and has long been an area where Indian expertise surpasses that of the West.

The diamond trading community also fears that many diamond businesses will shift their cutting and polishing operations to Belgium and Israel, countries that dominated the diamond industry before India became the major player in the field. Praveen Shankar Pandya, past chairman of the Gem and Jewelry Export Promotion council, said, “players may now shift their businesses to Belgium and Israel though we will try to see that it does not happen.” Thus, the PNB scam reveals the dangers to emerging market industries of a loss of credibility due to high-profile corruption.

Although Indian business leaders and politicians have announced potential solutions to prevent such high-profile corruption cases from repeating themselves, these “solutions” do not go far enough to address the problem at the core of the issue. On March 1, just weeks after news of the scam broke, the government approved the Fugitive Economic Offenders Bill that gave he government the power to confiscate assets of fugitive economic offenders. Although this bill was well-intentioned, it was clearly designed more to quell public anger at the individuals involved and desire to see those individuals punished, while not actually addressing the widespread corruption and unethical business practices at the heart of the issue.

A government reform passed in the wake of the scam that actually could go a long way in preventing similar scams in the future, is the Reserve Bank of India (India’s central bank) scrapping of the letter of undertaking as a banking instrument. The letter of undertaking had long been used by state-owned Indian banks like PNB to avoid doing due diligence themselves and to rely on foreign issuing banks to check Indian borrowers’ credit instead. This reform has more promise because it will incentivize Indian banks to improve their due diligence practices, including rooting out corruption among bank employees and generally improving the operation of the often bloated and poorly-run state-owned banks that dominate India’s banking sector. Potential future banking reforms include lessening state-owned banks’ control over the banking sector to introduce more private competition. In addition, a proposed reform supported by the Surat Diamond Association is the establishment of designated bank branches meant to deal exclusively with the diamond trade. All of these reforms could go a long way in improving the general efficiency of Indian banks and their dealings with the diamond industry.

As for reforms that could help weed out corruption in the diamond industry, one that has had significant success has been the Modi government’s demonetization campaign. This campaign, undertaken in November of 2016, involved the Indian government stripping rupee notes of certain denominations of their legal value and requiring that people convert existing notes in these denominations into other notes at banks. These notes were in the denominations that people most commonly used for under the table transactions and money laundering. Demonetization was part of the Modi government’s wider anti-corruption campaign. Although demonetization led to a temporary blip in India’s diamond industry because the vast majority of transactions were conducted in cash, the industry has bounced back stronger than ever after, as demonetization has resulted in many illegal and inefficient traders being forced to close down. This has caused business to shift to larger more reputable firms that have long relied on cashless transactions. This shift has been successful because global customers greatly prefer cashless transactions, thus increasing export demand for diamonds polished and cut in India. Although this reform intended to stop corruption in India did not stop the PNB scam specifically, in the long term, it has the potential to clean up an industry riddled with shady business practices at all levels, perhaps resulting in a business environment where such a scam could never have happened.