Low milk prices risk to banks

Dairy farmers are more vulnerable to rising interest rates than in the past. Photo / Mark Mitchell

Two years of lower dairy values will increase pressure on asset quality, says rating agency Fitch.

Two successive years of low milk prices will increase pressure on the asset quality of New Zealand banks, says ratings agency Fitch.

Fitch said the full impact of low prices will depend on how long they take to recover, the future direction of interest rates and on the level of the New Zealand dollar.

Fonterra last month cut its 2014/15 farmgate milk price by 10c to $4.40 a kg and set a $5.25 forecast for the current 2015/16 year - well below the break-even by most estimates and below the long-run average of $6 a kg.

Fitch said New Zealand banks were generally well capitalised, have strong profitability and sound asset quality.

"This gives them ample capacity to absorb impaired-loan levels similar to 2009-2010," Fitch said.

Dairy farmers account for the bulk of agricultural output, and dairy loans make up nearly two-thirds of total agricultural loans, while agriculture accounted for 14.5 per cent of total banking system claims in April 2015, according to the Reserve Bank.

Fitch said farmers were well placed to withstand weaker prices because of the substantial cash payout by Fonterra from the record 2013-2014 season.

Smaller payouts this season were widely anticipated following last year's drop in global dairy prices, and farmers have generally used last season's high prices and dividends to pay down debt or invest, Fitch said.

"Deleveraging should make the sector more robust, although supply could rise and prices fall further if farmers invest in fixed assets."

The depreciation of the New Zealand dollar since mid-2014 has cushioned farmers from the impact of global price falls by supporting prices in New Zealand dollars.

"Nevertheless, the failure of prices to recover towards the long-term average of $6 per kg of milk sold by mid-2015 will exert pressure on asset quality within banks' dairy exposures."

Last month's Financial Stability Report from the Reserve Bank projected that lower payouts could result in 25 per cent of dairy farmers experiencing negative cash flow.

Banks' credit assessments when lending to dairy farmers tend to incorporate long-term average payouts.

"If payouts remain below levels used for serviceability assessments, these may prove too generous for the most highly leveraged borrowers," Fitch said.

Reserve Bank analysis has shown that 10 per cent of dairy farms account for around one-third of sector debt.

Dairy farmers are more vulnerable to rising interest rates than in the past.

Reserve Bank data show that floating-rate loans amounted to 72 per cent of total dairy lending in June 2014, up from 16 per cent in 2008.

Lower milk prices could have an indirect effect on dairy loan asset quality, if lower farm incomes weigh on economic growth and sentiment sufficiently to influence monetary policy and reduce pressure for further tightening. However, this is far from certain.

Lower milk prices also widen New Zealand's current account deficit, increasing the economy's reliance on external funding. This could make domestic funding conditions more sensitive to changes in global liquidity and investor sentiment.

System impaired-loan ratios have started rising from cyclical lows in the six months ended March 31.