Risks to New Zealand's financial system from the once-highly indebted dairy sector have "diminished considerably" in recent years, the Reserve Bank said in its latest financial stability report.
Fonterra's latest forecast farmgate milk price for the 2021/22 season of $9.60 per kg of milk solids would represent a record payout level, although this may be slightly offset in terms of farm incomes by lower production volumes, partly due to dryer weather conditions, the bank noted.
The current strength in dairy prices may continue into next season, with limited prospects of global milk supply growth in the near term, it said.
"Overall, risks to the financial system from the dairy sector have diminished considerably in recent years."
The dairy sector continued to use the currently favourable conditions and low interest rate environment to consolidate and reduce its leverage.
On average, dairy farmers have repaid around $3 of bank debt per kg of milksolids in recent years.
"Total dairy sector debt has declined by around 12 per cent ($5 billion) since its peak level in 2018, reducing debt servicing costs, and meaning farmers will be better positioned to deal with any potential future downturn in dairy prices," the Reserve Bank said.
Banks continue to diversify their agricultural lending portfolios away from dairy to other industries, in particular horticulture.
The Reserve Bank said that while input prices are increasing, rising food prices are expected to be beneficial overall for New Zealand's agricultural sectors.
"With a predominance of pasture-based production, New Zealand's dairy, sheep and beef farmers are relatively less exposed than international peers to the disruptions to grain markets resulting from Russia's invasion of Ukraine."
In the near term, most agricultural industries are facing similar pressures to those in other businesses, including a tight labour market, input cost inflation, and disruptions to production from the Omicron outbreak.
Labour shortages are constraining production, including limiting fruit harvesting and leading to delays at meat processors.
However, most of these factors are expected to be temporary, it said.
"Against a broader backdrop of strong commodity prices, the continued diversification of banks' agricultural portfolios is positive for the soundness of the financial system."
Activity in the rural land market has been strong over the past year, supported by the low interest rate environment, and an increase in listings as owners reassess their holdings in the face of changing land use regulations and a rising carbon price.
Conversion of less productive land used for sheep and beef farming to permanent or production forestry offers attractive financial returns at the current carbon price, as afforestation is a relatively cost efficient means for New Zealand to reduce its net emissions under current technologies.
The Reserve Bank noted that the Government recently consulted on potential changes to the Emissions Trading Scheme that would disallow new, permanent, exotic forestry.
At the margin, the Reserve Bank said this could further raise the carbon price and incentivise more conversion of land into production forestry.