Andrew Gawith: Following the herd a questionable strategy

High milk prices have been a great boom to New Zealand, but assuming they will stay elevated could be a dangerous case of herd mentality. Photo / Christine Cornege

Opinion

Thank goodness for the dairy industry, for without it New Zealand would have been economically challenged over the past decade or two.

The value of dairy exports is now around $12 billion per annum, and they account for over 25 per cent of total goods exports. Their share of total exports has doubled over the last 20 years.

The growth of the dairy industry has been driven primarily by higher world prices for dairy products - according to ANZ's commodity price index the world price of dairy products has more than doubled since 2000.

The higher returns have made dairying a very bankable proposition thus spurring the expansion of the industry.

But is the economy becoming too dependent on just one industry, especially one so vulnerable to the weather, disease, trade impediments and world market conditions? Not to mention the fact that this industry is dominated by one player - Fonterra - that has an unusual and somewhat constrained commercial model.

At a quarter of all goods exports it's getting difficult to reject that suggestion.

The dairy industry also dominates bank business lending with around $30 billion of loans outstanding or just over 20 per cent of all business lending in the economy.

Banks have fallen over one another to fund dairy conversions, herd expansion, new dairy factories, etc. Any hiccup in such a capital dependent industry could have some uncomfortable consequences for the banking system.

The current ratio of impaired loans to the dairy sector is high - the Crafar farms and Dairy Holdings are just two high-profile examples of what is a wider problem of excessively indebted farmers.

It is true that by loading up on a "hot" asset, or in this case an industry, is a way to ramp up returns or national income - no doubt many investors wished they had pigged-out on Apple shares five years ago.

But just as a concentrated investment portfolio ratchets up risks, so also does a high dependence on one industry yank up the risks for an economy.

While the rising dependence on dairying carries dangers for the economy, the expansion of the dairy industry is an entirely rational response to the price signals.

Those price signals are global so it would be good to see more dairy farmers investing in production in other countries and Fonterra becoming a global dairy business rather than largely a New Zealand exporter; ie. diversification.

The dairy industry is vulnerable to the weather as any farmer will tell you. Too little rain is a problem, too much can also make life difficult.

To reduce the impact of weather on production, many farmers have invested heavily in irrigation.

Big advances in irrigation technology have been pivotal in expanding the available land for dairying.

The Government, bless it, is now providing substantial funding for irrigation projects to increase the area of farmland capable of milk production. Leaving aside the potential environmental risks of radically changing land use, such investment will further increase our exposure to dairying.

The devastating effect of the PSA bacteria on kiwifruit vines is a nasty reminder of the latent dangers for almost all agricultural production.

While foot and mouth is the obvious disaster scenario not only for dairying but also our meat industry, there may be other diseases that could specifically affect milk production. As dairy production pushes into new areas on an intensive basis we can be less certain what diseases or pests might emerge.

The world market for agricultural products is notoriously fickle both from an access and a price perspective.

That's not surprising - only a small proportion of the world's dairy production is actually traded - most countries are close to self sufficient and the international market for dairy products is where they go to cover a shortfall in domestic production or unload surplus production.

But this "clearing" market is where we go to sell the vast majority of our output.
World demand for dairy products has been relatively strong over the past decade or so, reflecting the rapid growth of incomes in emerging economies, particularly in China.
As noted above, that has led to a doubling in world dairy product prices. But it would be naive to think that New Zealand dairy farmers have been the only ones to respond to the higher prices.

Brazil's milk production has grown by 30 per cent since 2005 - the same rate as New Zealand's. And, as with most other things, China is in another league altogether: since 2000 China's milk production has increased almost four fold.

Sure that's from a low base but China now produces 70 per cent more milk than we do so it's reducing its need for imports, and as a worrying aside it has recently raised the tariff on dairy imports from New Zealand.

World milk production is undoubtedly responding to the high world prices of the past five or more years. Past experience and economic logic tell us that eventually prices will push supply ahead of expanding demand. At that point prices could head into a prolonged slump.

Interestingly, Fonterra's recent auction prices have been trending downwards - a short-term slip or the start of a slump?

It's too early to tell, but it sends a shiver through the economy and the banking sector given how much we have riding on dairying, and indeed on the acumen of Fonterra.

Andrew Gawith is a director of Gareth Morgan Investments, an investment manager, KiwiSaver and superannuation provider.