Friday, July 1, 2022

Dairy’s on solid ground

The dairy sector is in a strong financial position thanks to booming dairy prices.

Economist Cameron Bagrie says while there are some areas of agriculture that are concerning, he is not worried about the dairy sector

Red lights are starting to flash across some sectors of the economy. Omicron is knocking the economy’s economic capacity and containing inflation is not growth or asset price-friendly.

Every sector needs watching as Omicron’s tentacles spread, but the dairy sector is not on my worry list.

Labour shortages and uncertainty around environmental regulatory changes and compliance costs continue to weigh on the dairy sector, but cash is king and the dairy sector has a lot of cash courtesy of booming dairy prices. Profitability provides options and flexibility, including non-dairy asset accumulation as a diversification play and scope for innovative investment on the farm.

While riding the current commodity wave, dairying is one of the few sectors across the economy to improve its financial resilience in the past years. It is a story that gets insufficient attention.

Dairy sector debt has fallen to $37.1 billion, down a whopping $4.6b compared to July 2018. Debt has been falling at an average rate of $109 million a month.

The 2017 November Financial Stability Report noted dairy sector debt around three times dairy income. That ratio looks like it will be a tad over two for the coming season. Obviously dairy prices are a lot higher, but it is still a massive change.

Agriculture debt remains dairy-centric, but less so with more lending diversification taking place. Dairy sector debt has eased from 69.2% of total agriculture lending to 60.7%. Dairying will always account for a huge proportion of agriculture debt, given its significance in New Zealand’s pastoral exports.

Agriculture deposits have been rising at the same time total agriculture debt has been stable and dairy debt has been falling. While agriculture debt stands at $61.2b, deposits total $9b and deposits have risen $2.4b since the end of 2016.

The proportion of interest-only loans in the agriculture sector has fallen below 50%. Strong commodity prices over successive seasons have allowed farmers to increase their principal repayments.

Dairy sector debt has fallen below $20 per kilogram of milksolid produced. The proportion of loans defined as non-performing has been declining to around 1% of total loans.

The sector is on a far stronger footing to deal with any potential future downturn in dairy prices than it was 3-4 years ago.

The immediate challenge, though, is costs and inflation. Dairy farm expenses, according to Statistics New Zealand ,are up 7.7% on a year ago, exceeding the rate of generation inflation (5.9%). Those figures look light relative to what is being seen on the ground in the order of 10-20%.

There are an array of reasons. Covid and now the Ukraine crisis. Oil. Supply chain disruptions. Government policy. An economy that is too hot to trot.

The Reserve Bank is saying inflation will return to their 2% midpoint target. Interest rates are headed higher to achieve it. When interest rates move up you follow the trail of debt. Eyes on housing, which is already turning down, and Official Cash Rate is still just 1%.

There looks to be a more persistent inflationary undercurrent that the Reserve Bank cannot influence. We have structural shifts, including pushback against globalisation and climate change costs, to incorporate. A shortage of workers might not be a temporary phenomenon with the population ageing. Businesses will need to improve human resource practices to attract staff. Governments continue to spend big. 

Covid and the enduring impact on supply chains, including shipping, has exposed the relative inefficiency of New Zealand’s supply chain and under or poor investment in key infrastructure. It needs to be addressed for exports to be cost-effectively delivered to market.

The coming years will involve the three Rs: Reality, Reset and Real. We now face the reality of living with covid on an enduring basis; a reset in asset prices as interest rates normalise if income and productivity cannot be boosted; and some real hard work on key issues. The combination will be challenging for many. We now need substance as opposed to sugar-candy economics. 

Sectors which have improved their resilience in the lead up, such as the dairy sector, are far better-placed than many.

More: Cameron Bagrie is an independent economist and his views do not represent financial advice.

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