High world whole milk powder prices may make up for lost agricultural production.

The net cost to the economy of the drought could be close to zero thanks to the sharp gains in world dairy prices, say Westpac economists.

Westpac said the drought that has gripped the North Island and parts of the South Island was similar to previous droughts but with one big exception - it has been accompanied by very strong demand for dairy products from China.

The bank said Fonterra had gradually "cornered" the fast-growing Chinese whole milk powder market and that the drought had revealed its market power.

Westpac said in a commentary that the drought would hit agricultural production in the June and September quarters. "But incredibly, the net cost to the economy of the drought could be close to zero," it said. "World dairy price increases could offset the costs of lost production due to drought."


Individual dairy farm incomes for this season will vary widely from the nationwide average - particularly depending on access to irrigation.

The impact of the drought on the meat sector to date is negative and closer to the historical experience.

Higher dairy incomes would go a long way to offsetting lower production in both the dairy and meat sectors, particularly from the second half of 2013, the bank said.

"However, because this particular drought has had such unequal impacts on different parts of New Zealand's farm sector, there's also still some uncertainty around the flow-on effects on confidence and spending - those whose incomes get a boost may not raise their spending by as much as those whose incomes have taken a hit curtail theirs."

As the timing of higher payments to dairy farmers may lag behind the hit to production and as confidence takes time to return, dairy incomes may boost GDP later rather than sooner. Overall, the bank expects that the drought will have an impact of up to 0.6 per cent of real GDP over 2013.

Milk production had "fallen off a cliff" while sheep and beef slaughtering had shot to record levels because of culling.

In the past eight weeks, world whole milk powder prices have surged to record levels. In the four GlobalDairyTrade auctions to April 2, whole milk powder prices shot skyward, rising 62 per cent, largely as a consequence of the drought.

In the past five years, Chinese demand for whole milk powder has increased by more than 600,000 tonnes - or the equivalent of annual production in the European Union.


In annual terms, Chinese demand has grown by 11 per cent.

New Zealand has met most of this demand. "Chinese demand for dairy products and New Zealand production are now very much intertwined," the bank said. "With no other producers able to fill the gap, one thing has to give - prices.

"And Chinese mums insist on baby formula made with foreign milk powder - the majority of which is from New Zealand - no matter what the price - giving Fonterra market power in the whole milk powder market."

In these conditions, Fonterra effectively had market pricing power, Westpac said.

The drought had been the catalyst for this spike in powder prices - but the conditions that made this possible had been brewing since 2007 or longer, Westpac said.

New Zealand had doubled its whole milk powder production, and sent most of this increase to China, "leaving other major dairy exporters in the dust".

The meat sector has been affected largely in line with the experience of previous droughts - farm incomes will fall from last season, particularly for sheep farmers. And unlike the dairy sector, there has been no offset from higher prices.

Slaughtering has spiked to record levels as farmers move stock from parched pastures and in an effort to increase cashflows, leading to increased meat production over the March quarter.APNZ