Liam Dann: How serious is the dairy price slump?

Dairy products account for nearly 30 per cent of the country's merchandise exports by value. Photo / Brett Phibbs

Milk is still our economic lifeblood but a continuing slowdown in China could turn things ugly fast.

How worried should we be about the slump in global dairy prices? After all these years, New Zealand is still a giant grass-processing factory and milk remains the lifeblood of our economy.

In fact, dairy products now account for nearly 30 per cent of the country's merchandise exports, by value. That figure was closer to 20 per cent when I first started covering the sector more than a decade ago.

Dairy exports are on track to generate a record return in excess of $17 billion this year - about $4 billion more than they delivered on average across the previous three years.

That big return is due to a historically unprecedented spike in dairy prices that peaked in February.

So the 23 per cent fall in dairy prices since then is certainly significant. It has prompted Fonterra to lower its payout forecast for the 2014/15 season and is finally starting to put downward pressure on the dollar.

The currency traders woke up last week and the kiwi dollar slumped nearly half a cent after Fonterra's latest milk powder auction recorded a larger than expected drop.

That's good. At least it shows the system is working. Our dollar should fall when dairy prices do, it provides a natural hedge for our exporters and will be blessed relief for exporters in other sectors.

Dairy may be ahead of the curve in terms of New Zealand commodity export prices. It seems likely that a boom in log prices will peak this year. Other commodities like beef and lamb are also contributing to a record balance of payments.

If they start to fall too, that will add to the downward pressure. But really, for the bloke on the Wall Street trading desk who keeps an eye on this part of the world, the New Zealand story is all about dairy.

To put the other sectors in perspective, the $4 billion fluctuation in dairy returns between 2013 and 2014 is likely to be in excess of the total return for all lamb, mutton and wool exports combined last year.

So much for New Zealand living off the sheep's back.

Dairy prices are also where the attentions of the Reserve Bank are fixed.

The bank's economists won't be panicking just yet. They will be keeping the current prices firmly in context. The giddy heights that dairy prices reached early this year mean that even now they are sitting at historically high levels.

I can still recall the excitement in the dairy sector when Fonterra announced its first $7 payout - the figure Fonterra is picking for the 2014/15 season. That was a record and reflected the peak of the dairy price cycle in 2005.

If the price plateaus at that level then that would be a pretty sweet bottom end to the cycle.

There are good reasons - most of them to do with Chinese demand - why the global dairy price now has a much higher top and bottom than it had a decade ago.

But the trend will become concerning if it continues, and China is the great unknown.

Where the current slowdown in Chinese economic growth settles is anyone's guess. If there were to be a more serious and uncontrolled financial economic crisis in China then things could get ugly fast.

Meanwhile, good grass growing conditions and continued expansion of dairying in the South Island are driving increased production volumes which will prop up overall export returns to New Zealand.

A major drought next summer would still have a greater impact on New Zealand's economic outlook than the current dairy price.

What a slowdown in the dairy boom does do is remind us that we should maintain a firm focus on diversifying and expanding the economy into new and less commodity-focused areas.

Ironically, chief among those is the dairy sector itself. Fonterra is well aware that lower prices for milk powder will provide more opportunities to drive the brands side of the business.

Turning more New Zealand milk powder into yoghurt and baby formula before we export it suddenly makes even more sense.

Meanwhile, that $4 billion of extra dairy cash from the 2013/14 season still has to wash through the economy and should buoy domestic growth for a while yet.

Our "rock star" label won't stack up if our growth is all pinned to dairy and the Christchurch rebuild. Both of these factors have been timely in getting New Zealand ahead of the recovery curve in comparison with other nations - notably Australia.

The trick is to have the rest of the economy firing efficiently when we come out the other side.