Farm prices would fall by up to 40 per cent and banks would have to write off up to 15 per cent of their loans in a "worst case scenario" where dairy prices stayed at current levels for three more seasons, according to Reserve Bank stress tests to be released next week.
The scenario, which Reserve Bank governor Graeme Wheeler describes as the "nastiest and most difficult" of three modelled in April and November last year, would see most farmers living below the break-even levels for an extended period.
The Reserve Bank ran the stress tests with five major rural lending banks - ANZ, BNZ, Rabobank, Westpac and ASB.
"It presents a very challenging scenario," Wheeler said in an interview with the Weekend Herald yesterday.
"It suggested you could see loan losses of up to 10 to 15 per cent. You then look at the agricultural lending portfolio, that's roughly 10 per cent of total bank lending and much of that is dairy lending.
"Could the banks survive? Could they deal with that level of loan losses? Our judgment is that they could."
The Reserve Bank runs stress tests to ensure financial stability of the banking system.
While strong balance sheets, capitalisation and diversification were sufficient to ensure the banks survived from a stability point of view, such an extreme scenario would put additional pressure on the whole economy, Wheeler said.
"They'd be facing losses that would be affecting their profitability and that would be affecting their pricing."
One of the worrying things about the dairy situation is what's happening to global supply.
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It was a reasonable assumption that borrowing costs for New Zealanders would rise as a result of such a scenario as credit risk rose. "One of the worrying things about the dairy situation is what's happening to global supply," Wheeler said.
Milk supply in New Zealand had fallen about 4 per cent but in the US it was still rising - up about 1 per cent and it was up by 6 per cent in Europe.
"That's a big increase," Wheeler said.
The trade embargo against Russia was diverting supply into markets where New Zealand had previously been very successful, including China.
Reserve Bank forecasts were projecting whole milk prices would stay around US$1974 a tonne until September before rising gradually to $3200 a tonne by 2018.
"We're of the view that the market clearing price is around US$3200 so that's getting back into a more normal situation," Wheeler said.
The GlobalDairyTrade auction website shows whole milk prices have ranged from US$5245 a tonne in April 2013 to US$1590 in August last year.