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Benje Patterson says LVR restrictions are not about to hit dairy farmers; they would be unworkable and may result in distorting investment decisions

Benje Patterson says LVR restrictions are not about to hit dairy farmers; they would be unworkable and may result in distorting investment decisions
A threat to financial stability?

By Benje Patterson*

The Reserve Bank sounded a warning shot to the dairy sector last week in its latest Financial Stability Report, with Deputy Governor Grant Spencer saying that high farm debt levels pose risks to financial stability.

Although the Bank was merely identifying a financial stability risk, some commentators have erroneously interpreted the warning as implying that LVR restrictions for dairy farmers are just around the corner.

At first brush, the $32.3 billion loaned to the dairy sector by banks (as at 30 June 2013) sounds like a colossal sum – particularly when one considers that dairying loans represents the banking industry’s third largest loan type behind residential mortgages and business lending.

Over the year to June 2013, dairy sector debt represented 9.2% of all lending by registered banks.

But before we jump to unfair conclusions about the risks posed to financial stability by the dairy industry, it is important to understand what really influences banks’ risk exposure.

The absolute proportion of the banking sector’s loan book that has been extended to dairy farmers (and how this dairy sector debt interrelates to other parts of banks’ loan books) comprises one dimension of risk exposure to the dairy industry.

However, the specific financial circumstances of these dairy farmers underpin yet another key aspect of risk exposure that can’t be ignored.

Decomposing dairy farm financial statements

The easiest way to get to the heart of dairy farmers’ finances is to decompose their financial statements.

This type of information for the average dairy farmer is available from DairyNZ’s Economic Survey.

We can use this information to better understand a farmer’s actual ability to service their debts and how much these debts represent as a proportion of a dairy farm’s total assets.

The ability of the typical owner-operated dairy farm to service debt can be measured by calculating a ratio of cash operating surplus to interest expenses (a type of interest coverage ratio).

During the 2011/2012 season, this ratio was 2.7, indicating that the typical dairy farmer had a comfortable amount of residual cash to cover their finance costs.

However, as the Reserve Bank has pointed out, this debt servicing ability can rapidly deteriorate if milk prices fall or interest rates increase – this type of deterioration occurred during the 2008/09 season when the ratio plunged to 1.1.

Even so, despite this volatility, the past five seasons have generally been good, with this ratio of interest coverage averaging 2.3.

A key point to bear in mind when considering debt servicing ability is that one bad year isn’t the end of the world. A farmer can tide themselves over during a lean season, so long as they have sufficient access to cash or short-run credit. This drawing on credit lines is precisely what occurred during the 2008/09 season when operating cash flows were limited.

With these credit lines forming such an essential role in helping farmers manage their cash flows, it is important to understand what influences a bank’s decision to provide dairy farmers with access to credit in the first place.

To understand this decision, we must come to grips with farmers’ current mix of debt and equity, as well as what drives the value of farmers’ asset base.

According to balance sheet information from DairyNZ’s Economic Survey, the average dairy farm carried $3.02 million of debt during the 2011/2012 season, offset by $6.72 million of assets.

This financial structure left the typical farm with $3.70 million of owner’s equity.

At first glance, this appears to be a relatively healthy financial position, with more than half of all assets financed out of the farmer’s own pocket.

However, a bank’s willingness to extend credit also depends on what comprises this asset base.

DairyNZ’s survey shows that more than two thirds of a typical dairy farm’s assets were tied up in land/buildings, with livestock and investments accounting for most of the rest.

Given this high level of exposure to land values, it is not surprising that the Reserve Bank has singled out farm prices as a vulnerability of farmers and stability in the banking sector.

Even so, this vulnerability still needs to put in perspective by thinking about what really drives farm prices.

The Reserve Bank identifies the outlook for commodity prices as a key determinant of dairy farm values, which makes sense as these prices are a proxy for expected returns from the farmland.

The Bank appears to be of the view that dairy prices will soon ease from their exceptionally high current level.

Although I agree with this idea in principle, the international picture, particularly in China, suggests that any moderation is likely to be small, implying that dairy prices will remain at a historically elevated level over the medium-term.

Bear in mind that even though economic growth in China is slowing, the mix of Chinese growth is shifting away from investment and towards consumption.  This increased focus on consumption, coupled with changing tastes in other developing nations, will ensure that global dairy demand continues grow at a robust rate.

A bigger risk for dairy prices is the potential for other dairy producing nations to ramp up supply to chase these good returns. But even this risk is limited by the fact that not many of the other major dairy producing nations have lower cost models than New Zealand. Furthermore, in contrast to New Zealand’s pastoral system, many other major dairy producing nations are heavily reliant on compound feed prices which closely follow food commodity price cycles.

On balance, it seems that a sharp correction to both dairy and farm prices is an unlikely scenario at present.

Although this conclusion implies that risks to financial stability are contained for now, the Reserve Bank’s warnings regarding dairy sector debt still provide a prudent and balanced starting point for a discussion of risk.

The Bank’s comments should not in any way be interpreted as a prelude to LVR restrictions in the dairy industry.

The Reserve Bank knows full well that dairy LVR restrictions would be unworkable in practice and could result in inappropriate distortions to investment incentives.


Benje Patterson is an economist at Infometrics. You can contact him here »

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The 'land/buildings' aspect of dairy debt needs to be disaggregated to get any idea at all of susceptibility to land price variation.
There will be at least four significant categories of debt-funded capex within that heading:

  • Irrigation: bores (land) pumps and strings (equipment)
  • Milking sheds - as these are chock full of electronics if not robotics, will be a major component
  • Waste treatment - ponds, pumps, monitoring, consents, links to irrigation etc.
  • Land improvements:  races, underpasses, fences, waterways protection

And in any case, debt, however composed, is better understood as a fraction of current MS/kg prices.  This provides the core income/debt ratio. 
As well as that, production (KgMS) and farm area need to be stated. Then by comparing to provincial and national benchmarks of KgMS/ha, the productivity potential (which is surely the one of the  'capacity' factors banks will be very Interested in) is made clear.
Then and only then can anything truly useful be said about 'dairy debt'.

And we can add operatimng structure.
Dairy NZ also reports on sharemilkers. Often milk income is well shared before being presented for land debt servicing.
Scale counts - look at the SF result for this past year.
We are still working through embedding costs to drive production, against the natural strenght
Visiting Taranaki last year, he said New Zealand dairy farmers should continue to focus on the competitive advantage they gained from their ability to grow good grass.
This week he said they should operate a low-cost, low-risk system that enhanced their use of grass.
"They're targeting high production per cow, and that's putting them at risk because the milk price is cyclical."
Murphy said this year's US grain harvest was likely to be 2 per cent higher than normal, and the resulting low grain prices would stimulate milk production. This would lead to an increased international milk supply and a likely fall in the milk price next year.
"New Zealand farmers need to be careful not to allow their farm inputs to rise to a level where they will make a loss in a season with a lower payout. Volatility in the market is not dead. Losing their focus on grass is extremely risky."
He said high inputs required complex decision-making that only a few farmers could manage successfully.
"Only a percentage will succeed across cycles of volatility. All-grass farming means low risk, less stress and happier results."

Others are not so sanguine:
Institutional investors now hold 60 per cent of the $788 million Fonterra Shareholders Fund.
Fonterra has confirmed the institutional stake as concern emerges among dairy farmers that dividends to Fonterra's financial market investors will be be maintained despite an expected fall in profit. Stuff's Tim Hunter has more to say on the profit front.
In September, Fonterra forecast a 2014 dividend of 32c a share, matching this year's, while warning profits were likely to be hit by high milk prices.
"Fonterra can draw upon its balance sheet and cashflow performance to support the estimated dividend," New Zealand's biggest company said.
Large-scale Canterbury farmer Leonie Guiney said the concern is evidence that shareholders are looking beyond the short term and asking the "right questions".
She claims the Fonterra Shareholders Council - the independent watchdog set up to safeguard the interests of Fonterra's farmer-owners - is now powerless and its purpose obsolete. Read more

TAF was sold as a solution to redemption risk as a result of government regulations imposed on and accepted by Fonterra at formation. Pillaging the balance sheet to augment dividends calls into question the clarity and honesty of this rational. It is far removed from cooperative principles.

Fonterra elections are going to be interesting.  My mates around the traps say that there were some robust discussions at the candidate meetings re the dividend.
Another mate (insider) has said that the Shareholders Council cannot be seen to be disagreeing witht he Board in public.  From where I sit it is simply that which licks the boots of the Board.  Nothing robust coming from shareholder council.  Time for it to go, or grow some gonads and start truly representing the interests of shareholders.

"clarity and honesty"?

Have the per person TAF votes been published yet??

Looking at 'averages' when analysing bank debt to dairying is overly simplistic. Bank debt is highly concentrated into a small percentage of farmers who own multiple farms and very vulnerable to drops in the payout. When the payout dropped in 2008/09, banks then started to pressure highly geared farmers to downsize by selling some of their farms. This forced farm prices to drop and then it became very difficult to sell any farms. Bank's have not learned any lessons from this experience and have returned to funding dairy farmers on similar terms to earlier years. If the Reserve Bank don't impose some type of discipline on the banks then the next downturn will be worse thant hte last one.

them and new entrants, which in any venture are going to have high debt

New entrants?
I'm not aware of per person breakdown on TAF vote, as you know it was decided by share backed supply.

Mick, this is the type of analysis you refer.


The recent world economic crisis has affected NZ dairy farmers. Volatile milk prices, increasingfarm working expenses, and declining land prices have had solvency and liquidity implications.

Farmers need to change their business strategy from farming for capital gain and refocus onprofitability and positive cash profits. It is also likely that the rural lending environment and bankers attitudes will change. Once again farmers will need to respond to these changes.

Innovative economics Enhancing your strategic thinking Impartial. Rigorous. Quantitative.

You maybe right, as the Oz bank masters seem only to response to RBNZ rules rather than any bankers code.