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 borrowers underpin yet another key aspect of risk exposure that can’t be ignored.  Let’s now turn our focus to trying to understand dairy farmers’ specific financial circumstances.

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 identified 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, suggesting that dairy prices will remain at a historically elevated level over the medium-term.

The Reserve Bank points to slower economic growth in China as a key downside risk for commodity prices.  But it is important to 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.  However, 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.  This conclusion implies that risks to financial stability are contained for now, but the Reserve Bank’s warnings regarding dairy sector debt still provide a prudent and balanced starting point for a discussion of risk.  Even so, this does not mean the Bank’s comments should in any way be interpreted as a prelude to LVR restrictions in the dairy industry.  The Reserve Bank knows full well that such restrictions could lead to inappropriate distortions to investment incentives and the ownership structures of farms would make dairy LVR restrictions unworkable in practice.