Apocalypse Cow

That was the title of Wellington economist Peter Fraser’s talk at Victoria University last Friday lunchtime on why Fonterra has failed (it is apparently also a term in use in various bits of popular culture, all of which had passed me by until a few moments ago –  and a Google search).    Peter is a former public servant –  we did some work together, the last time Fonterra risks were in focus, a decade ago –  who now operates as a consultant to various participants in the dairy industry (not Fonterra).   He has a great stock of one-liners, and listening to him reminds me of listening to Gareth Morgan when, whatever value one got from purchasing his firm’s economic forecasts, the bonus was the entertainment value of his presentation.       The style perhaps won’t appeal to everyone, but the substance of his talk poses some very serious questions and challenges.

The bulk of Peter’s diagnosis has already appeared in the mainstream media, in a substantial Herald  op-ed a few weeks ago and then in a Stuff article yesterday.  And Peter was kind enough to send me a copy of his presentation, with permission to quote from it.

His starting point is with the misplaced belief among senior political figures 20 years ago that by allowing the creation of Fonterra –  using legislation to override the Commerce Commission – the door would be opened to the evolution –  in pretty short order –  of something equivalent to New Zealand’s Nokia.  In revenue terms, the promise had been

From a starting point of only $5B, they outlined a six-fold increase in revenues in only 10 years to $30B.

Critically, just under two-thirds of the $30B would come from what is euphemistically known as ‘value add’: specialised ingredients and biotech-heavy products.

So this was almost $20B of revenue from a starting point of ‘nothing’.

Actual revenue now, 17/18 years on, is about $20 billion (including a structural improvement in world dairy prices) and relatively little is from those vaunted specialised products.   The rate of return on that business, in turn, is barely higher than that on the bulk commodity business.


A much cited figure is the 2018 value report published by the International Farm Comparison Network (IFCN). This ranked Fonterra 17th out of the 20 companies in terms of value creation.

Its figures show while Fonterra collects the second largest amount of milk (and is the world’s largest milk exporter), its estimated turnover per kg of milk solids is only US60c.

By comparison, Danone is the 11th largest milk processor, but it turns over US$2.40 for every kg to make it the best performer. Nestlé is next at US$1.90 per kg. The average across the entire group is $1.00.

The “failure” is nicely illustrated in the share price (the non-voting shares were listed in 2012).   The comparison against the NZX index is stark, as is that against industry peers.

fraser 1

Apparently the share price fell further in June (and Peter told us that on Thursday the share price closed a touch below the initial valuation back in 2002).

Fonterra asset sales have been in focus this year.  They started when the market value of the company was much higher than it now is, and haven’t kept up, so that the ratio of market value to debt is now higher than it was.

fraser 2

For various reasons I don’t want to get into the fine details of DIRA, but as I understand the essence of Peter’s story is that:

  • farmers themselves never much cared about the added-value ideas (New Zealand’s Nokia and other dreams).  Why would they?  They are farmers, and their interests were primarily about a high price for their milk, and a high/rising price for their land.
  • between provisions in the legislation and in the constitution of Fonterra, the rules mean Fonterra has been paying materially too much (Peter says 50c per kg)  for milk purchased from suppliers,
  • dividends on the shares have been limited,  which doesn’t matter to (voting) farmer shareholders, but does matter to the outside shareholders, and retentions (or retaining earnings) –  now the main source of additional capital in a cooperative –  have also been low.
  • given Fonterra’s dominant market position, the too-high milk price also drives up the price of milk other industry participants have to pay.   That has encouraged more milk production – including “half way up Mt Cook”, and with associated environmental issues –  but also makes it difficult for firms to make profitable investments in other (value-added) products.

Peter again

…the idea of using the ingredients business as a springboard to a value creation business was part of the original concept and is actually a good one.

The problem is, it basically didn’t happen.  There are two reasons for this.

Firstly, Fonterra relies heavily on payout subordination so has very high gearing – something it seems the Board has failed to learn from after courting near disaster during the GFC.

This constrains Fonterra’s ability to borrow further, such as for acquisitions or to finance value creation activities.

The other problem is woeful levels of retentions, which are critical for a coop because without new capital from a growing milk supply, retentions are only other way of getting new capital.

So Fonterra remained a capital starved, deeply indebted and under performing farmer-owned cooperative.

That “near-disaster” ten years ago (his account here) was when I first met Peter.  Global funding markets was seizing up, world dairy prices had fallen sharply, land prices were falling, and lenders to dairy farmers were becoming seriously uneasy (including parents in Australia that hadn’t fully appreciated quite how much exposure, to a sector with very illiquid collateral, had been taken on).   In those days, struggling farmers had one buffer and Fonterra one exposure, that doesn’t exist today –  redemption risk (on the farmers’ own production-related shares in the co-op).

That particular risk has now been shifted back onto farmers, which probably leaves Fonterra’s own lenders a bit more comfortable (but in turn removed one discipline from the Board).  But there is still a hugely high level of debt (presumably largely from international markets and banks).

Peter argues that, unless something dramatic changes pretty soon, Fonterra is likely to run into crisis within the next five years or so (and, he argues, since the current government probably likes to believe it will still be in office five years hence, they really need to focus on this now).

I was among those at the presentation the other day who weren’t entirely sure how this mooted crisis would come about, or what form it might take.   After all, Fonterra isn’t a conventional company.  The traded shares –  the price of which has been falling away –  are not a direct stake in Fonterra.  The share price could go to zero (if, say, unit holders lost confidence there would ever be dividends, tied to value-added returns) without rendering the co-op itself insolvent.    The banks and bond markets that have lent to Fonterra are exceedingly unlikely to lose their money –  that is what (milk) payout subordination means –  but it is likely that quite a few of the existing facilities have caveats and covenants about financial conditions Fonterra has to meet.  And the asset sales programme of recent months seems fairly explicitly premised on the idea that the market price of the shares (and those the notional market value of the co-op) mattersa, including to lenders.    Presumably there has to be a risk that if Fonterra’s underperformance continues, lenders would become increasingly reluctant to renew existing facilities, and the costs of what credit they could still obtain would rise?

And, of course, there is only so much money to go around (perhaps rather less if commodity prices were to fall away sharply in a recession in the next few years), and what is paid to providers of capital (debt or equity) can’t be paid to farmers.  The dairy farm industry has an uncomfortably high, and rather concentrated, level of debt already. And dairy land values are underpinned, to a considerable extent, by the actual and expected milk price.  50 cents off the milk price for one year might not make much difference to land values, but if Fraser is right and prices are perhaps 50c too high generally, adjusting the milk price itself into line with that would severely impede the profitably of many dairy farms (as Fraser notes, on-farm costs have been rising, and much of any margin New Zealand dairy farmers had relative to the rest of the world appears to have been greatly eroded.  Fonterra also risks losing suppliers, and ending up with stranded assets.

The sketch outline of Peter Fraser’s story –  directional pressures – seems plausible to me, but here I’m mostly trying to tell his story rather than sign up to it all.  I don’t claim enough industry familiarity for that, and haven’t been exposed to serious alternative arguments –  if there are some, bearing in mind the repeated underperformance over a long time now.  The Fonterra statement to Stuff, in response to Fraser, didn’t instill great confidence

Fonterra managing director co-operative affairs Mike Cronin responded in a statement:
“Our focus right now is on the future of our co-op. We’re well down the path of a strategy review which will enable us to deliver on our potential and meet people’s expectations. We know where we want to go, but how we get there will take time. We will play to our strengths – our New Zealand provenance, our pasture-based farming model and our dairy know-how.”

Fraser’s presentation ended with these lines

fraser 3

That final line –  Westland as dress rehearsal –  is also where I want to end.    Fraser argues that, most likely, Fonterra will need extensive recapitalisation and that –  short of nationalisation –  there is no likelihood that the New Zealand market could provide the necessary capital, and thus that a foreign takeover is the most likely market solution.

Perhaps it would be the eventual market solution, but I struggle to believe that the market would be allowed to operate in such a case.  The politics of foreign ownership of Fonterra would be too much for any major political party –  in today’s climate – to swallow.  Most likely, we’d have government moneypots –  the New Zealand Superannuation Fund and ACC –  corralled to provide the new capital  (those two are already half owners of KiwiBank, and NZSF falls over itself to pursue politically-attuned projects).

If I read Peter correctly, he believes things could be turned around.  But that there is little sign of it from either Fonterra –  and no demand for it from their farmers –  or from the government.


Don’t legislate depositor preference

The government has underway a fairly comprehensive review of the Reserve Bank Act.  The first phase –  around monetary policy –  was pretty narrow in scope, rushed, and has resulted in not very good provisions now about to be legislated by Parliament.  I was always a bit sceptical about Phase 2, partly because of the way Phase 1 was handled and partly because the Minister of Finance had never displayed any particular interest in the issues.

But, for the moment anyway, I’m willing to revise my judgement.  Earlier last month a 100 page consultative document was released, the first of three as the Treasury and the Bank (aided by a somewhat questionable, secretive, independent advisory panel) work their way through the numerous issues involved in overhauling the Reserve Bank legislation and institutional design.

Yesterday, I attended a consultative meeting at The Treasury on the issues in the current document.  It was an interesting group of people and quite a good discussion, although even 2.5 hours is barely enough to do much more than scratch the surface on the wide range of issues in the document –  everything from the role of the Board to regulatory perimeter issues (including whether banks and non-bank deposit-takers should be subject to the same regulatory regime – most people seemed to think so).  Truly keen people can spend their summer preparing written submissions (due in late January).

What was striking –  part of what leads me to provisionally revise my view –  is just how much official resource is being put into this one review.  At yesterday’s meeting there were six members of the review team, and that wasn’t all of them –  and even they only report to their masters in the Reserve Bank and Treasury, many of whom will probably engage quite extensively on the issues. And the process has at least another year to run.  Despite having long championed the cause of reforming the Reserve Bank, I couldn’t help wishing that the same level of resource was being devoted to getting to the bottom of the causes, and compelling remedies, for New Zealand’s astonishingly poor long-term productivity performance.    There is little sign The Treasury has any resources devoted to that issue, the one that has the potential to make a huge difference to the lives of all New Zealanders.

But in this post I wanted to touch on just one specific issue that came up yesterday which surprised quite a bit and worried me quite a lot.   Chapter 4 of the document is devoted to the question of “Should there be depositor protection in New Zealand?”.  Of course, to the extent it adds in value at all, prudential regulation does help the position of depositors (reducing the probability of failure, and limiting the potential chaos if a major failure happens), but New Zealand’s legislation is unusual in that there is no explicit depositor protection mandate (the legislative goals are about the financial system, not individual institutions or their creditors).  Linked to that, we are now very unusual among advanced economies in having no system of deposit insurance.

I wrote about some of these issues, in response to a journalist’s queries, when the consultative document first came out.  But my focus then was on deposit insurance, and in particular on the realpolitik case I see for instituting deposit insurance, to give us the best chance that when a bank gets into serious trouble it will be allowed to fail, and its wholesale creditors –  the ones who really should know what they are doing –  can be allowed to lose their money.   Without deposit insurance, my view is that big banks will always be bailed out.  Perhaps they will even with deposit insurance, but by separating the interests of retail creditors from others, at least political options are opened.

But in focusing on deposit insurance, one thing I hadn’t really noticed in the chapter was the idea of providing depositors with additional protection by legislating depositor preference.  Depositor claims on the assets of a bank rank ahead of those of any other creditors.   Such a provision exists in the Australian legislation –  for Australian depositors.  It was a big part of the reason why New Zealand eventually insisted that Westpac’s retail business in New Zealand be locally incorporated (ie conducted through a New Zealand subsidiary).

To the extent I’d noticed the discussion of the depositor preference option, I’d assumed it was a bit of a straw man, there for completeness perhaps.  Surely, I thought, no one would seriously suggest that New Zealand adopt such a legislative preference.   But, going by the discussion at yesterday’s meeting, it seemed I was wrong and that officials are actually seriously considering this option.   They seem to see it as a complement to a deposit insurance scheme.  I think it would be quite wrongheaded.

In my incomprehension, I asked why  –  starting with a clean sheet of paper – anyone would think legislated depositor preference was a sensible route to consider.  The response seemed to be that it would be a way of reducing the cost of deposit insurance, and increasing the credibility of a deposit insurance scheme.  Both seem weak arguments, especially in the New Zealand context.

One argument sometimes advanced against deposit insurance is that in the event of a systemic financial crisis the cost could be so overwhelming that it would either over-burden public debt, potentially triggering a fiscal crisis, or lead to governments retrospectively walking away from the insurance commitment (simply legislating to not pay out).  In fact, we know that for reasonably governed countries that practical limits on the ability to take on new public debt are not very binding at all.   And we know that New Zealand has (a) very low levels of net public debt by advanced country standards, and (b) a banking system of only moderate size (relative to GDP) by advanced country standards.    Total household deposits with all registered banks are about $175 billion.  Not all of those would be covered by a deposit insurance scheme, even one that capped cover at a relatively high $200000.

Now lets assume something really really bad happens: banks lend so badly over multiple years that when the eventual reckoning happens loan losses are so large that 30 per cent of all bank assets are written off.   This would be absolutely huge –  far far beyond anything in Reserve Bank stress test, for beyond advanced country experience for retail-oriented banks.  But one can’t rule out by assumption utter disasters.  30 per cent of bank assets is currently about $175 billion as well.  There is about $40 billion of equity to run through, and then the creditors start bearing the losses.  Household deposits are about a third of non-equity liabilities, so in this extreme scenario the deposit insurer (and residual Crown underwriter) would face bills of up to perhaps $50 billion (a generous third of $135 billion of losses to be distributed across creditors and insurers).    And remember how extreme this scenario is: it assumes every bank in the system fails, and fails dramatically (not just slightly underwater), and that every household deposit is fully covered by deposit insurance.  In this really really bad, highly implausible scenario the bill presented to the depositor insurer is equal to less than 20 per cent of GDP.

Reasonable people can, of course, differ on whether deposit insurance is a good idea at all, just better than the likely alternative (my view), or something to be eschewed at all costs.  But in no plausible world would even a commitment of 20 per cent GDP overwhelm New Zealand public finances, or cast doubt on the ability of the New Zealand government to honour its obligations.   And none of this takes into account the likelihood that any deposit insurance scheme would be set up funded by insurance levies  Levy depositors, say, 20 basis points a year and you’ll be collecting (and setting aside) $350 million a year.  As I recall it, prudential policy (bank capital requirements) are currently set with a view to expecting systemic crises no more than once in a hundred years (the Governor the other day talked of extending that to once in 200 years).    If the really really bad systemic crisis hits in year 1, the government needs to borrow more upfront (recouped over time by the annual insurance fees).  If the really really bad crisis hits in year 150, there is a large pool of money standing ready, accumulated from those same annual insurance fees.

(Of course, in any scenario in which banks have lent so badly –  and regulators regulated so poorly –  that 30 per cent of all assets are written off, the economy is likely to be performing very badly for a while, and the public finances will be under some pressure anyway.  But those problems are there regardless of the resolution method chosen.)

The other argument I heard advanced for a legislated depositor preference is that it would reduce the cost of deposit insurance.    That might look like a superficially plausible argument, but it is almost certainly wrong in any economically meaningful sense.   Sure, if your bank is funded 50/50 by retail depositors on the one hand and wholesale creditors on the other, the chances that a deposit insurance fund will ever have to pay out to the depositors of that bank, in the presence of legislative preference, is very small (roughly speaking, losses would have to exceed 50 per cent of all the assets for depositors to be exposed to loss –  and thus the deposit insurer).    But if you don’t pay for your insurance one way you will pay for it another way.   If depositors have first claim on bank assets and all other creditors are legislatively subordinated, over time depositors are likely to earn lower interest rates than otherwise (less risk to compensate for) and other creditors more).   It might be hard to show this effect in the case, say, of the big Australian banks, but then no one seriously thinks the Australian government would do anything other than bail out those banks in the event of a crisis.  But we can see the pricing on existing subordinated debt issued by banks around the world – it yields, as you would expect, more than deposits.  It is much riskier.

Of course, it is true that legislating a depositor preference largely shifts the problem from the Crown balance sheet (underwriting the deposit insurer) to those of banks and their creditors.  That might look like a smart thing to do  –  internalising the issue and all that –  but in fact it is a subterfuge: trying to meet a public policy priority (depositor protection) by forcing banks to change their entire business model.  Much better to do things in a direct and transparent way: if you want deposit insurance, charge for it directly, and allow banks to determine how they operate their businesses (funding structures etc) given the insurance levies they face, and the market opportunities.  Doing so also operates more fairly – and efficiently – across different types of banks.  Depositor preference accomplishes nothing at all  in a bank that is 100 per cent deposit-funded, and such institutions should be competing on a competitively neutral basis with other banks with different mixes of funding.

In the consultative document, and again in the discussion yesterday, officials seemed to see a model in which wholesale creditors are exposed to more risk as a “good thing”, conducive to effective market discipline.  I’m with them on that point in so far as people -especially wholesale creditors –  who lend to banks should face a real risk of losing their money.  But depositor preference in effect says that the only way non-depositors can lend to banks is through instruments on which the losses mount extremely rapidly if anything goes wrong.  There is no good case for that (even if, as some do, you think it is reasonable to require banks to issue some tranche of subordinated or convertible debt).   It is a doubly surprising argument to hear mounted in New Zealand where for years –  and especially since 2008 –  we have been repeatedly reminded of the heavy exposure of our banks to offshore wholesale funding markets.   None of those holders has to take on exposure to New Zealand or New Zealand banks.   Legislate depositor preference and what you will do is to significantly increase the risk of those funding markets, for New Zealand, freezing, and yields on secondary market instruments going sky-high, at the first sign of any trouble, or even just nervousness.    Retail runs are one issue to think about, but as we saw globally in 2008 wholesale runs can be just as real, and perhaps more threatening (and lightning fast) –  I discussed the Lehmans story here.

I hope the legislated depositor preference option is taken off the table quickly.  It has the feel of clever wheeze intended to ease the path for deposit insurance.  Much better to make the case –  and there is a sound one –  for a properly funded deposit insurance scheme on its own merits.

On a totally different subject there was a surprising article in the Herald yesterday in which a former MPI official was discussing openly concerns held in 2008/09 about the potential financial health of Fonterra.   I was involved in this work at the time, working at The Treasury, and have always been a bit surprised that there wasn’t more open analysis of the issue at the time.  Just drawing on public information, the combination of:

  • a quite highly indebted cooperative,
  • largely frozen international credit markets (not just for banks),
  • highly-indebted farmer shareholders,
  • a model in which shareholder farmers could redeem their shares in Fonterra when their production dropped,
  • a drought the previous year (reducing production) and
  • low product prices, encouraging some farmers to further reduce production, and
  • the potential for some highly-indebted farmers to be sold up by their banks

was a pretty obvious basis for some vulnerability.    Fortunately, the particular extreme combination of risks never really crystallised.   One aspect of the 2008/09 crisis that was always interesting was –  in the words of one investment bank CEO at the time –  “one of the few markets that remain open is the New Zealand corporate bond market”.  That was because it was, and always has been, primarily a retail market, different from the situation in many other countries (reflecting regulatory differences).  In early 2009 Fonterra was able to run a highly successful domestic retail bond issue.  Subsequent changes to the Fonterra capital structure mean that in future serious downturns, redemption risk is no longer a consideration.  That, however, leaves more of the (liquidity) risk on farmers themselves.

A dairy stress test

I’ve been a bit slow to get around to writing about the material the Reserve Bank released last week about the dairy stress test it conducted with the five largest dairy-sector lenders late last year.

I’ve long been of the view (and on record here) that, almost no matter how severe the dairy situation becomes, dairy loans would not represent a threat to the soundness of the New Zealand financial system.  That is a top-down analysis based on

  • the size of capital of the New Zealand banking system (around $36bn),
  • the overseas ownership of all the main dairy-lending banks, and the absence of correlated exposures in most of them (dairy loans aren’t a big part of the Australian parents’ books),
  • the fact that any losses on the dairy book will crystallise gradually, allowing other retained earnings, or outside injections of new capital, to buttress the overall position of the New Zealand banks, and
  • that while dairy losses could in time be a part of a wider set of banking system losses (eg if severe losses also mounted on the housing portfolio), it is almost inconceivable that in such a scenario New Zealand’s exchange rate would not fall a lot further.  A NZD/USD exchange rate of, say, .39 (where it got to in 2000) covers over quite a lot of weakness in the international prices of whole milk powder (in turn mitigating the severity of the dairy losses themselves).

There are counters to each of these points, but in the end I think they come down to this: if the Australasian banks ever face really large losses on their housing loans, the banks could be in trouble.  I think that is very unlikely: house prices are held up by a combination of regulatory land use restrictions and population pressures, and vanilla housing lending has rarely if ever collapsed a banking system (as the Reserve Bank itself has acknowledged).  You might disagree, but my real point is that dairy loans themselves aren’t going to threaten the soundness of the system. Much wealth will be lost.  And many of the individual loans may have been ill-judged (by borrower and lender) but that is a different issue, and almost in the nature of a market economy operating under (the real world) conditions of uncertainty.

That is all top-down perspectives. But the stress test was useful precisely because it aims to be a bottom-up approach: working with the banks on how their actual dairy portfolios would behave under two pre-specified scenarios.  Note what the exercise wasn’t: it didn’t look at the implications for loans to dairy companies themselves, or to suppliers to the dairy industry (companies or farmer), and also didn’t look at the impact on loan losses elsewhere in the portfolio resulting from the stresses on the dairy sector itself (eg retailers or builders or residential mortgages or… in dairy-dependent towns).  Note that it was also only a rather provisional exercise, indicative more than definitive, and a basis for ongoing discussions between the Reserve Bank and individual banks.

stress test extract

That does tend to suggest we should use the higher loss estimates rather than the lower ones (since banks have fewer incentives to overstate the loss implications than to understate them).

Here are the scenarios the Reserve Bank specified.

stress test scenariosI’m largely going to ignore Scenario 1 from here on.  As the long-term average real milk price is probably only around the assumed 2017/18 level, Scenario 1 doesn’t represent much of a stress test at all.  The banks and the industry would have to be have been very rickety for a scenario like that to have presented a banking system problem.  I think the Reserve Bank should also have discounted these results, rather than highlighting them in their press release.

Scenario 2 does look much more like a real stress-test.  But even if one thought the series of payout assumptions might be reasonable (2015/16 won’t have been that low, but some of the out years could still be lower than assumed here), I was surprised by the dairy land price assumptions.  Despite a really severe adjustment in the payout path (absolutely, and probably relative to farmer expectations), dairy land prices are assumed to fall by just under 40 per cent (the cumulative effect of those three annual falls).

That might sound like a lot, but:

  • when the Reserve Bank did its housing stress test, it assumed a 50 per cent fall in Auckland house prices.  People still need to live somewhere, while they don’t need to farm cows.
  • we’ve already a dairy land price scare not long ago.  Here is a chart of the (“hedonic”)dairy land price index the Reserve Bank developed for REINZ (despite which, we don’t have general access to the series).

dairy farm pricesIn a single year, dairy land prices fell by more than 30 per cent –  and that was a severe, but very short-lived, fall in milk prices, and a rise in dairy non-performing loans that was still moderate compared to what we see in Scenario 2 in the current stress test.   Perhaps deliberately, the Reserve Bank’s stress test does not seem to have taken account of a second round of selling (forced or voluntary), and the potential for that to drive land prices well below what might be a longer-term equilibrium level.  Overshoots routinely happen in such markets, where liquidity is thin to non-existent, uncertainty is rampant, and potential buyers are few.  As Eric Crampton’s discussion highlights, one difference between now and 2009 will be that potential buyers are probably much more aware of how significant the barriers are to any offshore buyers (who might otherwise be a stabilizing force in the market).

Loan losses evaluated on total dairy land prices falls of perhaps 60 per cent might be a more realistic stress test –  recall, that stress tests aren’t central predictions, they are a scenario to test robustness against.  Loan losses went up by 5 percentage points on the move from the (not very stressful) Scenario 1 to Scenario 2.   The pattern of losses on loans should rise non-linearly as the test gets more stressful, and moving from a 40 per cent land price fall scenario to a 60 per cent scenario is a bit more of a land price adjustment than moving from Scenarios 1 to 2.

There are lots of other points of detail I could question (some things in the article just aren’t made as clear as they could be), but will just highlight one.

The Reserve Bank has long emphasized the desirability of having a capital framework for banks in which risk weights (whether imposed by the Bank, or flowing from the internal models of the major banks) do not have the effect of making capital requirements pro-cyclical.  If capital requirements fall in asset booms and rise in shakeouts, the capital requirements will tend to amplify credit and asset price cycles (an existing stock of capital will go ever further as the boom proceeds, and ever less far – encouraging banks to rein in lending even more –  as the bust proceeds).  And yet the stress-testing article suggests that pro-cyclicality is deeply embedded in the modelling, at least for the dairy portfolio –  itself the largest single chunk of banks’ commercial lending.

Here is what I mean.

risk weights dairy

This chart shows the average risk weight for the banks’ dairy portfolios under Scenario 1.  Recall that Scenario 1 was not very demanding at all, and yet the average risk weight on dairy loans increases by 60 per cent  (eg, from, say, 70 per cent to 112 per cent).  No doubt deliberately, the Bank does not reveal how much further risk weights increase in the much more onerous Scenario 2.     Even if it is not that much further, this sort of highly pro-cyclical pattern of risk weights looks like a bug that needs some serious attention.

To recap, in Scenario 2, bad debt expenses average 8 per cent of dairy exposures.

dairy bad debts

But, as the Bank noted (see extract above), not all banks were as conservative as others.  If we take the pessimistic end of the Scenario 2 range, we would have bad debt expenses of perhaps 11.5 per cent of dairy exposures.  But, as noted above, the near-40 per cent fall in land prices  in Scenario 2 still looks too shallow for such a fully-worked-through scenario.  If land prices were to fall 60 per cent would it be implausible that in such an scenario, with all the second round effects accounted for and allowing for the non-linear loss profiles, the banks could face losses not of the “3 to 8 per cent of their total dairy exposures”  that the Reserve Bank highlighted, but something more like 20 to 25 per cent of their total loans to dairy farmers?    I deliberately pose it as a question, rather than a confident assertion, and it is –  deliberately – the result of a stressed scenario, but it is probably a question people should be posing to the Reserve Bank.

Labour and the dairy debt

It often isn’t clear quite what the Labour Party means.  Andrew Little is reported as follows:

Little said the banks needed to be “stiff-armed and told we’re not going to see, wholesale, farmers pushed off the land”.

His only argument for this sort of intervention –  whatever it means in practice –  appeared to be that

“We expose more New Zealand farm land to the risk of overseas ownership and I think that is a matter in which there is a national interest the Government should be alert to, and take action on.”

Which all sounds quite dramatic, and yet what follows seems like a rather damp squib.

A summit should be called and dairy cooperative Fonterra should be at the table. Farmers needed to agree on a long term plan for the cooperative to move its products up the value chain, even if that meant taking less cash out once the immediate crisis was over, to allow Fonterra to invest to generate better long term returns.

Government assistance should be provided to get farmers over the crisis, in a similar way to the help offered during drought, but it did not need to be any more than that.

So, apart from more talk, what is Labour actually proposing?

Keen as any individual bank might be to be rid of some of the more questionable exposures in its dairy book, it seems unlikely that banks, as a group, will be that keen on precipitating large scale exits from the dairy industry.  Force one farmer to sell and there won’t be any material impact on the value of dairy farms more generally.  Try to force several thousand to do so, and (a) it will be next to impossible to find buyers in the short-term, and (b) the value of the collateral banks hold could collapse.  The Reserve Bank talked last week of an extreme scenario in which dairy farm prices fell by 40 per cent, but in an illiquid market like that for dairy farms there is no reason why land values should not fall by much more than 40 per cent if serious stresses were to develop.   No one really knows what dairy land is worth in the longer-term (where will oil prices settle, where will the New Zealand real exchange rate settle are just two of the many relevant questions) but it is the sort of market where it is quite easy to envisage a severe overshoot.  I’ve been tantalized for several years by parallels to some of the very illiquid mortgage-backed products in the US –  not the ones that eventually saw huge defaults, but the ones where prices massively overshot in a climate of fear and illiquidity.

If each bank would prefer to be rid of some of its dairy exposures, each of them also knows that farm lending is going to be a major area of credit exposure in New Zealand for decades to come.  It isn’t like lending to, say, a new industry which comes to nothing and goes away.  If some individual farmers will leave the industry, the rural sector will still be around and collective memories can be powerful forces for good or ill.  Banks were scarred by their experiences in the last major rural debt shake-out  in the 1980s, and I doubt they will be eager to burn off goodwill among future potential clients.  That doesn’t mean there won’t be forced sales, but it is hard to envisage the major rural lending banks rushing for the door  (no matter how much unease the risk departments of bank HQs in Sydney or Melbourne or Utrecht might be feeling).

In some ways, a more concerning scenario for banks might be borrower panic.  If enough farmers concluded that they were working for nothing and that there was no prospect of serious relief in the next few years they could, one by one, just choose to (try to) exit the industry.  Of course, they’d still have to find buyers, but in a climate like that collateral values could collapse anyway.  From the perspective of banks, it may be preferable if most farmers doggedly fight to stay on the land, allowing banks to make the calls on who to sell up and when, having regard to the potential impact on the rest of their national dairy portfolios.  No individual farmers cares much about that.

But I still have no idea what, if anything, Labour is proposing the government or the Reserve Bank should do to “stiff arm” the banks, to prevent widespread sales.  I’m pretty sure there are no existing legal powers that could appropriately be used for that purpose.  Of course, behind the scenes all sorts of threats and pressures could be brought to bear, but surely that isn’t how we want to country to be run?    So if Labour’s call means anything much they must be talking of new special legislative provisions.    There was a great deal of resort to such measures in New Zealand during the Great Depression of the 1930s –  allowing writedowns of loans, and of interest rates. Perhaps one could mount an argument for those interventions –  on a basis of a totally unexpected collapse in the entire price level, an issue in macroeconomic mismanagement  –  but what would the case for intervention now be?

It seems pretty clear that any dairy debt losses are not likely to be large enough to threaten the health of the financial system –  especially, as this is a slowly developing situation in which banks have plenty of time to bolster their capital buffers if that is required.   And to bailout individual farmers, or the sector as a whole, would represent a material new source of moral hazard –  a message to borrowers that they need not bear the consequences of their bad choices.  That would only increase future demand for debt –  in an industry that seems likely to continue to face considerable output price fluctuations

Of course, it may be that there is nothing much to Labour’s call at all –  other perhaps than a desire to be heard.  I’m not a fan of government assistance to farmers experiencing drought conditions –  if managing weather risk is not one of the things farmers have to do, I’m not sure what is –  but if Labour is talking of things only on that scale then I probably couldn’t get too excited.  Then again, action on that scale doesn’t seem likely to make the sort of difference that would prevent “wholesale” exits and large scale increases in foreign land ownership.

Perhaps that “foreign land ownership” issue is really at the heart of Labour’s call.   I’m not an absolutist on foreign ownership of land.  After all, to be blunt, large scale English purchases of New Zealand land in the 19th century –  even if mostly, individually, on a willing-buyer/willing-seller basis, did rather dramatically and permanently change the character of the country.    But in the current situation we seem very far from that sort of risk.  And in the shorter-term, the best hope for embattled farmers, and lenders, is the presence of a contested market of keen potential buyers.

And what of the call for a summit?  It seemed like a pretty tired old suggestion, and it isn’t obvious what the role of the government is in such industry issues.  We’ve heard endless talk over the years of “moving up the value chain” and farmers (the Fonterra owners) might reasonably be sceptical of the results to date.   But summits about long-term industry strategy don’t seem that relevant to the issues of the current overhang of farmer debt.

Do I have any sympathy for indebted dairy farmers?  Yes, to some extent.  There are individuals and families involved, and the stresses –  as in any struggling small to medium business –  must be pretty intense and hard to cope with.  It isn’t something those of us who spent our working lives as government officials never face.  Then again, the upsides in the good years are also pretty extreme.  Running a leveraged business is a high-variance operation.

Cyclically, of course, farmers would be somewhat better off if we had a Reserve Bank that was doing its job better.  With core inflation probably around 1 per cent, and real interest rates higher than they were a couple of years ago (and real retail rates probably higher than they were at the start of the year), there is simply no need for the OCR to be anything like as high as it is now.  The OCR isn’t, and shouldn’t be, set with a view to supporting dairy farmers (or people in any other specific sector) but an OCR more consistent with the Bank’s own Policy Targets Agreement would (to a small extent) ease farmers’ financing costs and be likely to result in an exchange rate rather lower than it is now.  We saw the impact of last Thursday’s surprise (itself mostly a timing surprise).  It isn’t obvious that the OCR at present needs to be any higher than 1.5 per cent.  At that level, we’d be likely to see the exchange rate quite a bit lower again, and every cent off the exchange rate raises the prospective payout to diary farmers, materially affecting prospective profitability of people in the industry.  Not many farmers probably did contingency plans in which the TWI would still be above 71 even with WMP prices at current levels.

For the longer-term, if governments want to focus on more structural issues, there is a whole range of policy measures which help and hinder the dairy sector.

The ability to import large numbers of foreign dairy workers acts as a direct subsidy to the industry –  holding down industry-specific wages rates – and has probably largely been capitalized into rural land prices.   Water quality rules have been being tightened, but the ability to pollute, and pollute without paying, is another subsidy to the dairy industry.  Subsidised irrigation schemes go in the same direction.  None seems well-warranted.

And on the other hand, all tradables industries in New Zealand suffer from our very large scale immigration programme.  Whatever monetary policy is doing, the resulting quite rapid growth in the population keeps upward pressure on the real exchange rate, driving up the price of non-tradables relative to the (largely fixed) global price of tradables.  That makes it harder for firms operating here to compete in international markets, and helps explain why the per capita output of the tradables sector as a whole is no higher now than it was 10-15 years ago.    We shouldn’t be reorienting our immigration programme around the short-term needs of particular industries, but the biggest single factor New Zealand has some control over that would help the dairy industry at present would be a lower exchange rate.  A much lower immigration programme would, among other things, achieve that.  It might also allow a more hard-headed longer-term conversation about some of those industry subsidies.

Dairy: another day, another price slump

In the last 24 hours we’ve had two gloomy headline indicators out. The ANZ Commodity Price Index for July was out, with a record 11 per cent fall in the world prices of New Zealand export commodities. And the latest GDT auction saw another 10 per cent fall in whole milk powder prices, with portents of further falls to come.

Neither piece of news was that surprising on the day, but to say that is to risk underestimating the severity of what has been going on.

As the ANZ notes, the latest fall was the largest fall in the almost 30 year history of their series. What they didn’t mention is that it was the largest fall by a large margin. By an even larger margin it was the largest monthly fall in world dairy prices.

anz monthy changes

On the ANZ measure, the scale of the fall in commodity prices in the last year or so now matches what happened during the 2008/09 recession.

ANZ Commodity

For dairy prices themselves, the fall in the GDT index now materially exceeds the scale of the fall in 2008/09. Real dairy prices now appear to be around the lowest levels for 30 years – although not necessarily at levels wildly inconsistent with trends up to 2006.

ANZ commodity real USD dairy

The fall in commodity prices didn’t cause New Zealand’s recession in 2008/09. A drought didn’t help. Neither did lingering inflationary pressures that for a while made the Reserve Bank reluctant to cut the OCR. And, of course, there was the recession that engulfed the rest of the world, which in turn helped exaggerate the fall in commodity prices. So I’m not suggesting that the falls in New Zealand commodity prices necessarily mean we are now heading for negative GDP quarters, but the loss of national income is now large and the risks of some pretty bad outcomes must be rising. There are no forces operating in the other direction, to boost growth rates. The real exchange rate is only around 10 per cent below the average for the previous couple of years – as I pointed out the other day, that is a pretty modest adjustment by historical standards.

For a few years, I’ve been intrigued by how little growth there has been in real value-added in the agricultural sector. The terms of trade have been high, and in particular world dairy prices have been high, and yet over 10 years or so there has been almost no growth in what SNZ record as real value-added in the agricultural sector. Here is the most recent version of a chart I’ve run previously.

agriculture real GDP

Total factor productivity growth in agriculture has also been quite remarkably weak.

I’ve noted previously that some of this may have reflected the incentives of rising prices. It is well-known that dairy production processes have become much more input-intensive over the last decade or more.   Much of that is about supplementary feed, but it also includes irrigation and other more capital-intensive production models.  In principle, in the face of high product prices these additional inputs could improve the profitability of the agricultural sector, even though the real (constant price) value-added is not increased. If more inputs are being used to produce more outputs, and those outputs can be sold profitably, then it is just one of the ways in which farmers (and their suppliers) capture the benefits of the rising terms of trade.

I was never sure quite how persuasive that reassuring story was. But a reader has got in touch to point me to some papers which suggest that things might be nowhere near as rosy as that story suggests. A basic proposition of economics is that one should produce to the point where the marginal revenue from the additional production equals the marginal cost of doing so. Beyond that point, one starts losing money on every additional unit of production.

I don’t suppose anyone imagines that this model exactly describes how any single business actually operates.   But it is a tendency towards which economists typically, and implicitly, assume that firms in a competitive market will gravitate.  Why, for example, would one produce more if you were going to lose money on each new unit of production. And in the rural sector, where land is huge component of inputs, a farmer generating the highest rates of profit should be able to bid a higher price for land. Resources should gravitate to those best able to use them.

But there is no guarantee of this happening, especially over relatively short periods of time.

In their paper “The intensification of the NZ Dairy Industry – Ferrari cows being run on two-stroke fuel on a road to nowhere?”, presented at an agricultural economics conference last year, Peter Fraser and two co-authors (Warren Anderson, an academic at Massey, and Barrie Ridler,a Principal at Grazing Systems Limited) argue that many New Zealand dairy farmers have been applying anything but the principle of producing until marginal revenue equals marginal cost.  I spent quite a bit of time working with Peter during the 2008/09 dairy price crash – I knew about debt but he (at MAF) knew, and taught me, a lot about dairy. I have a lot of time for his (often-trenchantly-expressed) views.

Fraser et al argue that most of the farm models used by farmers and their advisors in New Zealand take an average cost approach rather than a marginal cost approach, which is inducing increases in production beyond the point of profit maximisation.

none of the mainstream dairy industry farming simulation models (e.g. the Whole Farm Model, Farmax, DairyMax, Udder) and performance measures (e.g. information derived from Dairy Base or Red Sky, benchmarks such as milksolids per hectare, average profit per hectare, gross farm returns, production at x percentile, etc.) are economic models or measures as none employ marginal analysis. As a result, none can profit maximise at a farm level and all are likely to lead to a production decision where marginal costs are greater than marginal revenue.

They argue that this misinformation has not been driven out by competitive processes partly because many dairy farmers are not necessarily setting out to be profit-maximisers.

The corollary is that if farmers are focused on accumulating assets then a ‘satisficing’ position of having sufficient cash flows to pay drawings and to service debt is likely to suffice. Critically, this can also explain why more resources are flowing into the dairy industry: farmers are willing to borrow (and banks willing to lend) in order to accumulate assets (and potentially realise [untaxed] capital gains, especially if converting a dry stock farm into a dairy farm, as this is akin to property development).

In short, a combination of systemic misinformation combined with farmer motives can go a fair way towards explaining why a $10 note may be left on the pavement after all.

One can debate whether this explanation for why is wholly persuasive (the more aggressive dairy developments in recent years, seem far removed from the traditional Waikato or Taranaki (satisficing?) family dairy farmer), but the fact that many farmers are not getting good marginal-based advice and analysis does seem reasonably clear.

Fraser et all go on to support their case with results from a Lincoln University model farm, suggesting that using more sophisticated models (using marginal analysis) profit maximisation would typically result from milking fewer cows (per hectare).

The argument appears to be that much of the growth in total milk production in New Zealand in recent years (perhaps 10-15 per cent of total production) is resulting from an average-cost led focus on boosting total production, rather than maximising profits. Even at the higher prices that were prevailing until recently, production volumes should probably have been lower (the authors also note the potential environmental benefits).

Quite how all this feeds into thinking about the current situation, and the likely response to falling payouts, I’m not sure.   Marginal revenue is plummeting, and even an average-cost based approach would presumably lead to some reduction in production. On the other hand, there is an awfully large stock of debt to service, and maintaining production levels remains sensible if (but only if, and only to the extent that) current payouts are covering short-run marginal costs.

Relatedly, a reader notes:

I would contend that the family farming structure adapts more readily to the pressure of a price slump. The corporates’ general means of survival is by committing more capital to sustain an existing production plan. Family farms shift more quickly into survival mode and if the household has a trained nurse or teacher sends her back to work to support the family household! The dairy industry in its drive to maximise total production has blithely discarded the flexibilities inherent in the cooperative based systems developed over the previous 150 years. It seems there may be a price to be paid for that negligence.

On which note, however, I have long been struck by the production response of the New Zealand dairy industry to the collapse of export prices in the Great Depression   If one didn’t price the farmer’s family labour, short-run variable marginal costs were presumably extremely low, and there was a great deal of debt to service.

dairy depression

I don’t claim expertise in this area, but I found the analysis stimulating and one reconciliation for those otherwise puzzling GDP data I showed earlier. It does look as though participants in the industry will need to think harder about how best to maximise returns, not just production. I like driving obscure and remote roads when we travel the country on family holidays, and I’m often prompted to wonder about the economics of collecting milk from the remote suppliers that linger in such places, and just how long that can go on.  On its own that is a small issue, but perhaps symptomatic of an industry not yet adequately focused on medium to long-term profit maximisation.   Industry structure issues often crop up in the context of discussions like this.  Co-operative structures or not should be a choice for farmers – and they are common internationally in the dairy sector – but direct government legislative interventions facilitated the existing, less than fully competitive, industry structure. So far, the gains to New Zealand from having done so are less than fully apparent.

Dairy lending and the Minister of Finance

I saw this Bernard Hickey piece yesterday afternoon, and have been mulling on it since.

Finance Minister Bill English has admitted the Government and Reserve Bank are in discussions with banks to ensure they don’t prematurely force dairy farmers into mortgagee sales that could trigger a dangerous spiral lower in land values.

If accurately reported (which it may not be), it is somewhat disconcerting.  What bothers me is the notion that the Minister of Finance (and perhaps the Governor of the Reserve Bank, although there is no confirmation of any involvement by the Bank) thinks he knows better than banks how to run their own businesses. Ministers of Finance often aren’t very good at presiding over the government’s own businesses – Solid Energy or Kiwirail anyone?

During the 2008/09 recession I did quite a lot of work at Treasury on dairy debt. Debt, and dairy land prices, had run up extremely rapidly in the previous few years, and there was concern about what the fall in commodity prices, and the seizing up in international funding markets, might mean for the dairy sector as a whole, and for those who financed them. I reminded the perennial optimists that the long-term real average dairy payout had been around $4.50 and that it would seem unwise to be planning (whatever one might hope for) on anything much higher in the medium-term future.

During that period, I took to describing dairy debt as “New Zealand’s subprime”. My point here was not that large losses were inevitable (in fact, in that episode NPLs did pick up quite notably, although not in a systemically-threatening way), but that the nature of the risk exposures were not generally well understood. At the time, banks were very dependent on wholesale market funding, and few offshore investors appreciated just how large New Zealand banks’ exposures to farms were (I recall checking out the US flow of funds data and finding that in an economy 100 times our size, farm debt in the US was only around 10 times that in New Zealand).

It was also never entirely clear that the Australian parents really appreciated the scale of the dairy debt boom, and competitive credit-supply war, their New Zealand subsidiaries had gotten into. And, of course, the market in agricultural land was not the most liquid in the world – like many markets there was reasonable liquidity in booms, and almost none in busts.   That illiquidity meant that it was very difficult for anyone to know the true value of the collateral underpinning dairy debt. As it was, dairy land prices fell very sharply (and never subsequently fully recovered the boom time peaks) even with very few forced sales. One of the risks of lending secured on farm land was that if one lender got very worried and starting a round of forced sales, it would seriously undermine the market value of the collateral other banks were holding. They all knew that – and they also knew about the goodwill in the rural community that had been burned off in the period of financial stress in the 1980s. And that created an incentive for what I describe as “hand-holding” – each tacitly agreeing (probably not in ways that create legal difficulties) to approach forced sales very very cautiously. That might seem a good outcome in some respects, albeit at the expense of transparency. In 2009 perhaps, with hindsight, it was: the downturn in dairy prices proved short-lived, and the recovery in the payout bought time for banks to manage out of their worst exposures.

But we didn’t know then, and we don’t know now, how long the low payouts will last for, and what either a market-clearing or equilibrium price for dairy land is. And when I say “we”, I include experts, stray bloggers, and the Minister of Finance and the Governor of the Reserve Bank. Uncertainty is a key feature of economic life, and one that people in positions of power too readily underestimate. There is probably a selection bias – people without a strong self-belief (and belief in their own views) tend not to end up at the top of politics. In some dimensions, the current position seems more worrying than the 2009 episode. Not much new debt has been taken on in recent years, and there hasn’t been a recent spiralling-up in land values. That suggests little risk of a systemic threat to the health of the banking system (but as I have noted previously it is not clear that the minimum risk weights the Reserve Bank requires on dairy exposures are really high enough). But, on the other hand, whatever is dragging milk prices so deeply down now is not the side-effect of a global liquidity crisis, the direct effects of which were reversed pretty quickly. Global commodity prices have now been trending down for several years, and there is little obvious reason to expect the trend to be reversed – although no doubt there will be plenty of volatility.

Perhaps there is nothing more to this story than a natural politician’s desire to sound sympathetic to business owners who find themselves in difficult conditions. I hope so.  But the Minister of Finance and the Governor of the Reserve Bank hold a lot of power over banks, and the fact that those statutory powers exist suggests it is even more important that the Governor and Minister avoid putting pressure on banks to make decisions that might suit a politician, but might not be in the interests of bank shareholders. Banks aren’t popular, but they are legitimate and important businesses, who are expected to make a return and act in the best long-term interests of shareholders. Plenty of times some discerning forbearance may have helped through a key customer in difficult times, but forbearance – whether by bank or regulator – can also be a recipe for worse problems, and bigger losses, down the track. The risks of that are much greater when people with no financial stake weigh in to try to tilt the attitudes of lenders. Neither the Minister nor the Governor has the information to make those calls well regarding dairy debt. In the Governor’s case, it is little more than a year since he gave this relentlessly optimistic speech, and I’m sure that without too much difficulty I could find similar examples from the Minister of Finance – it is, after all what ministers do.

Here is a link to my own piece on dairy debt from a couple of months ago.

Dairy debt

I’ve had a couple of questions about risks around the dairy debt, and since the sector intrigues me – and my wife’s family has quite a few present or former dairy farmers – I dug around a little more.

The Reserve Bank publishes agricultural debt data monthly, but debt by agricultural sub-sector is only available annually, as at the end of each June.  Last June there was $34.5 billion of dairy farm debt.  In the year to the end of March 2015, agricultural debt grew by 6 per cent.  If that was representative of dairy, there will be around $36.5 billion of dairy farm debt by the end of this June.

As I noted last week, the rate at which new dairy debt has been taken on (and made available by lenders) has slowed markedly since around 2009.  Dairy debt grew at an average annual rate of 17 per cent from 2003 to 2009, and by around 4 per cent per annum in the six years since then.   Last week I showed the chart of dairy debt to total nominal GDP –  it rose sharply until 2009/10, and since then has fallen back a bit.

A commenter reasonably pointed out that nominal GDP (incomes of everyone in the country) doesn’t service dairy debt.  That is quite true –  although any aggregate debt ratios (except perhaps those involving government debt) have somewhat similar problems.  My household’s income isn’t servicing any mortgage debt either, and yet charts of household debt to GDP or to disposable income are quite common. And people who have debt are different, in a variety of ways, from people who don’t have debt.  For some purposes, these sorts of ratios are useful, but sometimes they can mislead.   Micro data are great when they are available –  and I commend the work the Reserve Bank has done in using the data that are available for dairy.  As everyone recognises, dairy debt is very unevenly distributed: plenty of farmers have no material debt at all, while others –  often the most aggressive and optimistic industry participants –  have huge amounts of debt.  A net $25 billion has been taken on in only 12 years.  Unsurprisingly, there were some nasty loan losses in the 2008/09 recesssion.

But sticking with aggregate measures, what about some other denominators?  This chart shows dairy debt as a percentage of annual dairy export receipts.


The last observation is an estimate –  using the 6 per cent debt growth for the year to 2015, and assuming that the June quarter’s dairy export receipts bear the same relationship to the June quarter of 2014, as the March quarter of 2015 bore to the March quarter of 2014.  It will be wrong, but any error won’t materially affect the picture.  The stock of dairy debt this year will be just under 2.5 times the latest year’s dairy export receipts (industry sales, if you like).  Note that that is less than the average for the 12 years for which we have data.  That just reflects the fact that the fall in global commodity prices takes a while to feed into actual dairy export receipts.  On present trends –  including another fall in the GDT price yesterday – dairy receipts will fall a lot in the coming year, unless the exchange rate were to fall sharply.  But it is hard to envisage, at this stage, that the fall in dairy receipts will be enough to take the ratio of dairy debt to exports above the previous peak.  At a time when there was a lot of very new debt, reflecting exuberant attitudes among lenders and borrowers alike, that previous peak generated a nasty fall in rural land values, and some material losses for lenders, but no systemic threat.

Statistics New Zealand produces annual data on the GDP and gross output of the dairy sector.  Unfortunately, it is only available with a considerable lag.  Fortunately, dairy export data and dairy sector gross output data line up quite well.


When the data are available, we will no doubt see that dairy sector gross output and GDP rose quite sharply over the last couple of years.  The year to March 2015 will no doubt be a record high (in as much as record levels of nominal variables mean very much).  And then it is likely to fall back.  But again, on international dairy prices as they stand now, and the exchange rate as it is, it seems unlikely that nominal gross output or GDP for the dairy sector will fall much below the previous peaks – $10 billion gross output, and $6 billion of GDP.  If so, again it is difficult to see where material banking system stresses could arise from –  even though it will no doubt see some more exits, and quite a bit of nervous hand-holding by the banks.

It is worth briefly reflecting on the $6 billion of dairy GDP.  That does mean that dairy farmers on average have $6 of debt for every $1 of GDP they generate –  and among the indebted farmers that ratio will be much much higher.   That would be much higher than the ratio of household sector debt to household sector income, but then much of the household debt is supporting consumption not production.

So what could go really wrong?  The usual story around dairy debt is that if New Zealand’s export commodity prices collapse then the exchange rate should also be expected to fall sharply, mitigating the adverse impact on New Zealand dollar prices, and probably on local rural land values too.  That hasn’t happened so far.  There are some obvious reasons, including the  Reserve Bank choice to hold policy interest rates above the level that was required to have kept inflation on target.  And weak as dairy prices are now, our overall terms of trade still don’t look likely to fall to any sort of historically low level this year.   But if global dairy prices don’t fall much further, and the exchange rate hangs around current levels, or falls, there isn’t likely to be any systemic threat arising from the dairy debt.  The nightmare scenario is one in which, for some reason, the exchange rate rises sharply from here, even as commodity prices stay weak.   One possible scenario we toyed with a couple of years ago was a very disruptive new euro-area crisis, in which somehow currencies like the NZD and AUD became seen as some sort of refuge in the storm.    It isn’t likely, but then tail risks matter.  The experience of 2008/09 also argues against it: then both the NZD and AUD fell very sharply as speculative risk appetite unwound, even though the crisis had nothing directly to do with our two economies. It would seem likely that, eg, a disorderly break-up of the euro would be at least as large a trigger for hunkering down, and a  quick flight to safety, that didn’t involve a surging NZD TWI.

I noted last week that deflation remained the biggest (if remote) medium-term threat to the stability of the New Zealand financial system, as its loan books are structured currently (debt ratios pretty flat, debt stocks growing slowly).   But the dairy sector debt should be relatively immune to that threat.  I think it is pretty common ground that if the OCR were ever cut to zero, or slightly negative, the NZD TWI would fall sharply,  The main attraction in holding NZD assets over the years has been yield pick-up, and when that vanished-  as it did in 2000, when the Fed funds rate briefly matched the OCR –  so does any strength in the NZ exchange rate.  Of course, during the Great Depression deflation did pose huge problems for New Zealand’s farm debt, but getting a downward adjustment in the exchange rate then was a much more difficult and political process.  The then Minister of Finance resigned in protest when the government finally imposed a devaluation –  these days if things went badly a sharp fall in the exchange rate would seem much more likely to be welcomed.

And, finally, one of the more sobering graphs I’ve seen in recent years ( there are many to choose from).  This is real agricultural sector GDP, which is available quarterly (albeit prone to considerable revisions), shown alongside total real GDP.

ag gdp

There is quite a bit of variability of course  – droughts etc  – and this is the whole agricultural sector, not just dairy, but over the 10 years or so that the terms of trade have been strong there has been almost no growth at all in real agricultural sector GDP.  Representatives of the manufacturing sector are prone to lament how manufacturing activity has been squeezed out, but actually even farm sector GDP has been tracking well below growth in total real GDP.   In some respects, things might be a little better than the picture suggests.  High dairy prices have encouraged greater use of more intensive production systems –  more irrigation and more supplementary feed.  Those inputs allow the production of more outputs, and the outputs can be sold for a higher price than previously.  In other words, more money might be being made in dairying, even if the real (constant price) value-added in the diary sector hasn’t changed much.  Ultimately it reflects the fact that there has not been much business investment taking place in recent years in response to the higher terms of trade – a very different picture from what was seen in Australia.  If commodity prices settle back at pre-boom levels that may be no bad thing[1] –  fewer wasted resources –  but if, as the optimists believe, the long-term prospects for global agriculture, and the sorts of products New Zealand produces in particular, are very good then it might end up looking like something of a last opportunity.   Daan Steenkamp wrote up some of this material at more length in a Reserve Bank Analytical Note last year.

Nasty financial crises usually follow fairly hard on the heels of periods of exuberance –  surging asset prices, surging credit stocks, downward revisions in credit standards, and so on.  In respect of dairy, all of those things were present in 2008, but they haven’t been in the last couple of years.  That suggests that the systemic risks associated with the high level of dairy debt are low.  Yes, an overhang of high debt stocks could still cause severe problems if a particularly unusual set of circumstances were to arise –  there is always a hypothetical shock which could, in the extreme, prove too much for an indebted industry – but that is simply to say that all business, in a competitive market economy, involves taking risk.  As consumers, we should not want it any other way.

[1] And the dairy component of the ANZ Commodity Price Index (expressed in USD terms) is now only around 10% higher in real terms than it was when the series began in 1986.

Some other aspects of the FSR

In its Financial Stability Reports, the Reserve Bank consistently highlights two other areas of risk:

  • Dairy debt exposures of the banks
  • New Zealand’s quite large net international investment position

In this post I want to offer some thoughts on the nature of these risks, highlight perhaps a bigger risk that has never received a mention in an FSR, and end with a few thoughts on how the Reserve Bank might better think about FSRs.

Dairy farmers owed banks around $35bn as at June 2014.  That is more than the total capital of the banking system, and is the largest sectoral exposure of the New Zealand banking system.   Since each dollar of farm debt is generally regarded as much riskier than a dollar of housing mortgage debt it can’t be ignored as a potential area of threat to the banking system.  It also makes the New Zealand banking system different –  when I checked a few years ago, farm debt in New Zealand was about one tenth that in the US, even though US GDP was perhaps 100 times that of New Zealand.

The Governor made much yesterday of the fact that dairy debt had trebled since 2003.  What we didn’t hear so much of is when that debt increased.  The chart below shows dairy debt as a percentage of GDP.  It rose very very rapidly to 2009, and has gone nowhere – actually fallen slightly – since then.


During that boom period, dairy land prices rose very sharply. Land prices fell a long way in the recession and even in the last couple of years land prices have been below the previous peaks (even in nominal terms).  It matters when the debt was taken on.  The worst of the loans taken in the boom –  and there were some pretty bad ones, as banks fell over each other to build market share, and buyers got sucked into some sort of bubble mentality –  have already failed.  Bank non-performing loans in respect of dairy exposures rose quite sharply over 2009 and 2010.  They could easily have got a whole lot worse, if the payout had stayed down for longer, and if banks had not all quietly recognised that in an illiquid market like that in dairy farms in a downturn, selling up many clients would rapidly drive the value of collateral even lower.

I did quite a lot of work, and thinking, on dairy risks in 2009.  I used to stir people up by describing dairy debt as potentially ‘New Zealand’s subprime’ –  potential for bad debts, exposures ill-understood both by parent banks and by offshore funders, and a market for collateral that was highly illiquid and, hence, with little effective price discovery.  And New Zealand has been down this path before – farm debt was a major problem in New Zealand, with all sorts of regulatory interventions, during the Great Depression. So I’m not complacent about the possibility of dairy risks.  But timing  matters a lot.  Not only has the worst of the boom-times debt already failed, but bank parents got quite a fright in 2009, and banks have had plenty of opportunity to manage their exposures over the last five years or so, including encouraging – or forcing – clients to take advantage of the good years to reduce debt levels.  I’m a bit of a pessimist on global commodity prices so it wouldn’t surprise me if farmers had a pretty tough few years ahead.  And in any sector where there is a boom followed by bust, some people will be caught out, and some will exit the industry.  But this is not 2009, and the chances of any material systemic threat, based on bank dairy books as they stand now, seems incredibly low.  A fresh dairy credit boom and land price spiral would be something quite different, but the last one was years ago now.

But I had some sympathy with the call I heard this morning for risk weights on dairy exposures to be raised.  My sympathy has nothing to do with the current situation, but with a fear that the weights were set too low in the first place.  Back in June 2011, the Reserve Bank published two Bulletin articles about dairy debt in the same issue.  One was a stress-testing exercise which used a plausible scenario that ended with 20 per cent of dairy loans having to be written off.  The other described the work the Bank had done on recalibrating risk weights for farm loans.  The authors reported that average risk weights on farm loans would in future be around 80-90 per cent.  That meant banks would be required to hold capital equal to perhaps 7 per cent of farm exposures (given that the minimum total capital requirement is 8 per cent of risk-weighted assets).  Requiring banks to hold insufficient capital to cover the Reserve Bank’s own contemporaneous stress test looked odd then, and still does now.  As I noted, current risks don’t look that large, but capital requirements are supposed to be set to be robust to all different phases of the credit and economic cycles.

(Incidentally, this is an example of a more general problem.  Would, for example, the Bank’s capital requirements for insurers be large enough that if the Christchurch earthquakes were repeated –  a real world stress test if you like – AMI would not have failed?  Given that the government chose to bail-out AMI at taxpayers’ expense, with the support of the Reserve Bank, and has shown no sign of regretting doing so, some questions might reasonably be asked.)

The Reserve Bank has long made much of New Zealand’s relatively large net international investment position (as a per cent of GDP).  It doesn’t make Chapter 1 this time round (which is welcome) but it is still there in later chapters, including the “Systemic Risk and Policy Assessment”.  New Zealand’s NIIP position is large by international standards, but it has been large for decades, and has shown no signs in the last 25 years of getting any larger.  That is a very different position from where countries like Spain and Greece found themselves in the years leading up to the euro crisis,  when NIIP ratios increased very rapidly.   New Zealand’s NIIP position is a symptom of some  persistent imbalances in the economy, but it is a chronic condition, not one that threaten crisis.   In fairness, the Bank now mainly focuses on rollover risk for domestic banks’ foreign funding, but even here I think they overdo it.   Even in the 2008/09 crisis, wholesale term funding markets were closed for only a relatively short period of time.   There was never any sign of idiosyncratic concerns about the Australian and New Zealand banking systems, even though on any objective measures the risks must have greater then than now.   Global market disruption – as, say, we might expect if the euro breaks up in a disorderly way –  could increase the cost of borrowing (as happened in 2008/09) but that effect can largely be offset through a lower OCR.  It just is not a first order risk for the soundness of the New Zealand financial system.  Wholesale funding can be an indicator of systemic vulnerability, but usually when wholesale funding has been running up rapidly because lending growth is far outstripping domestic deposit growth.  We went through that phase –  and our financial system got through it largely unscathed –  but it is not today’s risk.

I have been struck for some time by the absence of the word “deflation” from Financial Stability Reports.  For all my relative comfort about the health of the New Zealand financial system, the one thing that could really threaten it would be a period of significant deflation.  Why?  This isn’t Fisherian debt deflation story, but simply a reflection of the fact that almost all private debt is nominal.  If we were to experience a period of sustained deflation nominal asset prices could be expected to fall, and nominal wages (and profits) would also be expected to fall.  Those holding financial assets would be better off, but those with financial liabilities could be in quite serious strife.  For banks, the risks are entirely asymmetric – they don’t benefit from the increased real wealth of their depositors, but are heavily exposed to the increased real debt of those they have lent to.

Material or sustained deflation is not a high risk in New Zealand.  No doubt 25 years ago the Japanese didn’t think so either.  Deflation isn’t a non-existent risk for New Zealand either, especially in the current global environment – adverse demographics, the increasingly pervasive “bite” of the zero lower bound etc.  I’m not sure why the Reserve Bank is so averse to discussing the nature of the risk, even as an extreme scenario.  Yes, we know they have an inflation target of 1-3 per cent annual inflation, but there is no guarantee that a central bank will always be able to keep inflation up to current target levels and who knows what the future target will be.    This is one of those areas where the Governor, in preparing the FSR, needs to take off his hat as monetary policy decision-maker and just deal with the possible threat to the banking system – remote, but not impossible.

This post has ended up a little longer than I’d intended.  I want to finish with just a few thoughts on how I think the Reserve Bank should approach future FSRs.  In assessing risk, they seem rather stuck in a pre-2008 environment.  Back then, credit growth was very rapid across all classes of bank loan books, the finance company debacle was nearing its worst, asset prices generally were rising rapidly, banks were becoming progressively more dependent on short-term wholesale funding, and constant pressure was on to lower effective capital requirements (in the shift to Basle II).  It was quite reasonable to have entered 2008 quite concerned about possible threats to the health of the system.  But the New Zealand financial system came  through that severe recession, and the aftermath of a big credit boom, largely unscathed.  And almost nothing in the description of the pre-2008 years is relevant today.

Some of what has changed is just the result of market phenomena, but some is a result of worthwhile regulatory measures: higher minimum capital requirements, strong pushback against the pressure to erode risk weights, new liquidity and funding requirements and so on.  Some years ago, senior staff of the Bank’s Prudential Supervision Department used to tell the IMF each year that they presided over the safest banking system in the world.  That used to grate somewhat with the house pessimists (of whom I was one).  And yet, as it happened, they weren’t so far wrong.  The Bank should take some credit for the health and soundness of the financial system.  Of course, a central bank needs to keep a watching brief on emerging threats, but needs to be able to differentiate when they pose real threats to the soundness of the financial system, and when they are just the sort of thing that strong buffers are already in place to contain.  More energies might reasonably be put into reviewing the extensive regulatory net now in place –  not just to “iron out inconsistencies” (the sort of approach in the current regulatory stocktake) but to ask, and to invite serious outside perspectives on, what bits of the regulatory framework are really adding material value to the statutory goal of promoting the soundness and efficiency of the financial system.