Nathan Penny: Gear up for a bumpy ride

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Nathan Penny presents a rough guide to the economic effects of the food price boom

Westpac economist Nathan Penny.
Westpac economist Nathan Penny.

Higher world food prices are here. China and other developing countries are richer and hungrier. We produce good food and they are buying. In fact, they'd like more than we and others can produce. As a result, those high food prices are here to stay.

Overall this is good news for NZ Inc. Farm incomes are receiving a boost and as a result, so will the economy. But higher food prices will also force change on other sectors: they will have to adapt. So what's this "new normal" going to look like?

First off, get used to a bumpy ride

World food markets are as tight as a drum. Food producers are struggling to keep up with rapidly rising demand from China and other developing countries where incomes are growing fast.

The OECD expects world food production to rise a miserly 1.5 per cent over the coming decade, compared to more than 2 per cent in the previous 10 years. Under this new global order, food prices have become sensitive to small disruptions to production.

A drought similar to the Northern Hemisphere drought in 2012 could raise world food prices by 15-40 per cent.

For New Zealand, and our leading food export, dairy, the balance is even more delicate. This year's local drought pushed world whole milk powder prices up by more than 80 per cent in the space of four months.

Changes in New Zealand production will be offset by world prices moving in the opposite direction. Though the the timing may be slightly off, total farm revenue will be more stable as a result.

. . . although it is a nicer ride

Gyrations aside, food prices are high and set to stay there. In May, world prices for New Zealand's export commodities were the highest on record.

On the other hand, import prices, helped by the dollar, are low. Shoes and clothes have never been cheaper relative to incomes.

Using some economist jargon, this combo results in a terms of trade that are high (see chart).

Put more simply, this means our trading partners are willing to give us more pairs of jeans or Hiluxes for every tonne of milk powder or chilled lamb we produce.

A higher terms of trade increases the economy's income as a whole. Moreover, townies and farmers alike would benefit from a higher currency making imported goods cheaper. And with our dollars going further, our living standards lift.

Agricultural investment will boom too

From multimillion-dollar irrigation projects to new quad bikes and everything in between, agricultural sector investment is set to boom. This is the next stage of higher food prices and higher agricultural sector returns. In general, more people will be looking to make a buck.

This higher exchange rate also makes imports cheaper. Machinery, equipment and farm technology are cheaper relative to hiring more workers. So while employment in the sector will still grow, agriculture will become more capital intensive than it already is.

Though other sectors will suffer...

To this point the outlook is rosy, but the food price boom will throw up some major challenges.

Sectors outside agri such as manufacturing and tourism will face the biggest challenge. As agri sucks in labour and other resources, these sectors will be forced to pay more to keep hold of their workers. Hence, their costs will rise, but these sectors have not benefited from higher prices. Profits will for them, in fact, fall. Moreover, the higher exchange rate will further hurt competitiveness in these sectors.

Higher Australian export prices pushed the Australian dollar to parity against the US dollar in 2010. Similarly, our dollar was at a record high on a trade-weighted basis in April this year.

...as costs rise

There is another catch. The agricultural investment boom will suck in resources from other parts of the economy. And to attract these resources firms will pay more for them. Construction costs, in particular, will rise.

What's more, we already have a massive investment boom in Canterbury.

An agricultural investment boom will compound competition for resources, particularly for labour. Westpac expects unemployment to drop to 5 per cent next year mainly as the Christchurch rebuild hits its straps. Construction costs are already rising 12 per cent per annum in Canterbury.

For us economists, it's less a question of will there be enough people, but more of a question of how much will it cost to get them here. As we have seen from the mining boom in Australia, pay people enough and they will live in the desert (or fly in for the month).

During Australia's resource boom, some planned mining investment projects were canned as costs become prohibitive. The same may happen here.

Interest rates will be higher here

This investment boom will mean higher interest rates. As stated the battle for resources will push up costs, particularly wages and eventually lead to higher inflation. Eventually, this will force the Reserve Bank to raise interest rates to prevent inflation from running away and the economy overheating.

These are just a few of the economic consequences of a food price boom. We have much to celebrate - NZ Inc will be better off. But it will force change on the economy, and often change is tough. But for the most part, enjoy the bumpy ride.

Nathan Penny is an economist at Westpac

- NZ Herald

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