Federated Farmers: Dairy prices will impact farmers

Dairy prices will impact farmers.

There's no doubt that testing times are ahead for the dairying sector. World prices for dairy products have continued to plunge, as a surge in global milk production has collided with softer demand. It's uncertain where prices will bottom out, or how long they will take to return to levels that are more sustainable over the long run. But it's looking increasingly likely that the farmgate milk price for this season will be below $4/kg, well below the breakeven price for many farmers.

A second consecutive season of very low returns to dairying will inevitably have an impact on the wider New Zealand economy. Household and investment spending in rural communities is likely to be cut back. In addition, challenging conditions in the rural sector will feed through to lower confidence in the economy more generally. This signals downside risk for businesses' investment and hiring decisions over the coming year.

Just as farmers need to adopt practices that help them to ride out the rough patches, it's important for the economy to have some resilience to the inevitable shocks from overseas.

The single most important resilience mechanism for the New Zealand economy is the floating exchange rate. Admittedly, a floating currency will sometimes work to the detriment of exporters. But it proves its worth by adjusting lower during times of economic stress, effectively providing a safety valve for the economy. Anyone who doubts the importance of a floating currency need only read about the crisis in Greece, or of the miserable growth performance of many other countries within the single European currency.

That said -- and again using Greece as an example -- an ever-falling exchange rate is not a substitute for having good economic rules and institutions. New Zealand scores fairly well on this front. The central bank and government spending are constrained by legislation, making them more predictable and less vulnerable to short-term political gains. The banking system is well managed and capitalised, and has the support of large foreign owners. And New Zealand is able to borrow overseas in its own currency -- something that might seem obvious to us, but it's a privilege that is still denied to many developing countries.

However, this brings us to one of the economy's vulnerabilities. New Zealand has a relatively high level of overseas debt (largely through the private sector, not government), which has to be serviced and renewed on a regular basis. So we're still at the mercy of shifts in sentiment in overseas markets.

The Global Financial Crisis of 2008 was a dramatic example of this: access to overseas funding dried up for some time, not due to any specific concerns about New Zealand but because overseas lenders were trying to shore up their balance sheets. In some ways, this risk is an unavoidable part of being a small open economy; the best response to build up financial buffers during the good times.

Another concern is that the degree of concentration in New Zealand's exports leaves us vulnerable to weaknesses in particular markets -- for instance, dairying's current woes look to be specific to that market. Arguably, the problem is not about being "too involved" in producing commodities, but in being "not involved enough" in the value-added parts further along the supply chain. Note this doesn't necessarily imply that more of this work should be done within New Zealand -- ownership, not location, is the key to capturing the added value.

The lack of investment in value-added is partly related to the previous issue: New Zealand has a limited pool of investment capital and is reliant on overseas funding. There is no easy answer to this problem -- although addressing a tax system that gives favourable treatment to leveraged investment in property would be a start.