Trade Minister says dairy industry faces "excellent" future, but can't lose productivity gains made; Warns on debt

New Zealand's dairy industry faces an excellent future due to rising prices for its exports, but needs to hold on to and build upon productivity gains made between 1960 and 2000, Trade Minister Tim Groser says.

In a speech to the NZ Dairy Business Conference in Rotorua, Groser said the next 10 years were looking bright for the dairy sector, as the trend of rising commodity prices continued and as demand for NZ dairy products grew due to free trade agreements and a global search for safe food sources.

However, Groser also cast a warning on the dairy industry becoming too leveraged with debt, with the dangers caused by price volatility ever-present or even enhanced in recent years.

Productivity gains

A scenario of declining commodity prices in the period 1960-2000 only showed half the story, as the industry also experienced productivity gains, Groser said.

"It was all very well for the pessimists to point to the downward price trend; it was quite another matter to draw the conclusion that you would not want to produce a product that was on that declining curve," Groser said.

"The reason why that is so should have been obvious. Any producer of anything, whether a commodity or not, which is facing declining real prices can at least offset that price decline through continually higher productivity," he said.

"Nowhere is the real price decline faster than in many IT products. However, that does not mean that economies like Taiwan that are in that business are in the wrong business. Quite the contrary – it all depends on that other curve – the trend towards higher productivity. That is the story of NZ dairy 1960-2000 and why NZ dairy remained in business."

The growth of total factor productivity (TFP) in agriculture generally was far faster than in the economy as a whole.

"What does this mean for the future? Well, I think the answer is simple. If you, the dairy industry, can maintain the same pattern of annual average total factor productivity growth against the background, not of declining prices, but rising prices, you face an excellent future," Groser said.

"Frankly, a single visit to a research institution such as LIC should persuade even the hardest sceptic of NZ agriculture that total factor productivity growth of around 2% is entirely plausible," he said.

Warning on debt

Also in the speech, Groser made reference to the dangers of too much debt over equity in the dairy industry in the face of volatile price movements.

"When I look at world dairy markets today, against that historical perspective, I see a vastly improved situation that gives me every reason to be optimistic," Groser said.

"But against that optimistic outlook, there are some domestic realities that do not change. I recall giving a speech to a rural audience in 2006. The theme I had chosen was that NZ agriculture was not a sunset industry and would play as important a part in NZ’s future as it had in the past," he said.

"In the Q & A that followed, there was a young dairy farmer who would not have a bar of this. She got up and was straight into attack mode. Her target was the Government and Fonterra. The fact that I was then the Opposition spokesperson on Trade and therefore represented neither the Government nor Fonterra was to her a minor detail of no relevance. Dairy, she proclaimed, had no future in NZ and the sooner people like me understood it the better.

"She and her partner worked their proverbials off on their dairy farm and could not turn a dollar. The payout in those days was a little over NZ$4.20. I just asked her in return one question – what was the ratio of her equity to her debt? The question was, of course, a show stopper," Groser said.

"My point is, I think obvious. The global situation facing NZ dairy is unquestionably vastly improved but price volatility has not gone away – it may even, if we look at pricing events from 2008-2010, be enhanced," he said.

"As Warren Buffet put it so famously, it is only when the tide goes out that you can see who has been swimming naked. In this improved global situation for dairy, it is still possible to get over-leveraged, no matter what the pay-out price the previous season might have been. The need for prudence and effective risk management has not disappeared with this improved macro situation for dairy."

Read the full speech below:

We have in this room a few hundred people who will be critical to shaping the future of the industry over the next ten years. Appropriately, the theme of your Conference is “2020: Focussed on the Future”. I will put before you, in due course, five propositions – one could call them ‘mega-trends’ - that I think will drive the process forward; they are all closely linked with each other.

Before doing so, however, let me recount two anecdotes that draw on my involvement with the dairy industry. They are far from professional ‘highlights’ – quite the contrary, I would have foregone either event with great pleasure.

The first relates to the international context 25 years ago and is intended to show how fundamental the change in world dairy markets has been – and very much for the better. The second tale, is about the domestic setting for dairy in NZ and is, I suggest, a cautionary tale about how there are other things that never change from the perspective of the individual producer.

The year is 1986 or ’87. It was a period where NZ was locked into a bitter struggle with Europe over dairy. In Europe, this was the era of wine lakes and butter mountains – products of the vast agriculture surpluses built up by the then Common Agriculture Policy. It was well before Europe got serious about policy reform. Our dairy industry – as was the case with our sheep meat industry - had been set up as part of the UK food security system. Our supply chains had been fashioned to supply Europe and the European consumer. Markets everywhere else around the world were generally closed to NZ.

I was also Chairman in Geneva of a second-rate international organisation, now thankfully defunct, called ‘The International Dairy Agreement’. It was once defined by a famous French negotiator as ‘our (meaning EU) little OPEC with NZ’. It was an agreement designed to enforce internationally agreed minimum prices on key internationally traded dairy products. The Americans, furious at Europe’s manipulation of the Agreement, had walked out some years ago and were just observers. We hung in grimly, because it was literally better than nothing. Or so we had thought.

One day I woke up to be told that the EU, or EC as it was then known, had broken their minimum price agreement and dumped about a quarter of a million tonnes of milk fat, mainly AMF and butter, on the Russian market. So closed were world dairy markets, that in those dark days, Russia represented typically about 70% of the free global market for milk fats. It was a disaster for NZ, given the importance of dairy to our economy and the lack of alternative markets.

Well, ladies and gentlemen, some things do change and fundamentally so. When I look at world dairy markets today, against that historical perspective, I see a vastly improved situation that gives me every reason to be optimistic. I will elaborate on this presently.

But against that optimistic outlook, there are some domestic realities that do not change. I recall giving a speech to a rural audience in 2006. The theme I had chosen was that NZ agriculture was not a sunset industry and would play as important a part in NZ’s future as it had in the past.

In the Q & A that followed, there was a young dairy farmer who would not have a bar of this. She got up and was straight into attack mode. Her target was the Government and Fonterra. The fact that I was then the Opposition spokesperson on Trade and therefore represented neither the Government nor Fonterra was to her a minor detail of no relevance. Dairy, she proclaimed, had no future in NZ and the sooner people like me understood it the better. She and her partner worked their proverbials off on their dairy farm and could not turn a dollar. The payout in those days was a little over $4.20. I just asked her in return one question – what was the ratio of her equity to her debt? The question was, of course, a show stopper.

My point is, I think obvious. The global situation facing NZ dairy is unquestionably vastly improved but price volatility has not gone away – it may even, if we look at pricing events from 2008-2010, be enhanced. As Warren Buffet put it so famously, it is only when the tide goes out that you can see who has been swimming naked. In this improved global situation for dairy, it is still possible to get over-leveraged, no matter what the pay-out price the previous season might have been. The need for prudence and effective risk management has not disappeared with this improved macro situation for dairy.

Bearing these anecdotes in mind, let me put before you five propositions that I think will drive the industry forward in, say, the next ten years:

Proposition 1: A vast shift in relative power and wealth to the developing world is underway that underpins growing demand for protein.

Proposition 2: As a consequence both of this shift in purchasing power and breakthroughs in NZ trade policy over the past 25 years, the world trading outlook for dairy has improved, and is likely to continue to improve.

Proposition 3: While economic theory suggests a return longer term to commoditisation is possible, for the next, say, ten years, the long era of declining commodity prices appears to be in reverse. However, that does not mean the end of large price volatility. You have all heard of ‘caveat emptor’; this is a case of ‘producer beware’.

Proposition 4: the choice between increasing NZ dairy exports from our domestic production base and leveraging our huge IP in dairy by strategic investment in overseas is a false choice. We should and can should do both and the process of wealth creation in NZ requires both.

Proposition 5: our dairy sector is a dominant economic player in NZ. This imposes expectations and therefore responsibilities on the dairy industry. It is essential, as dairy production continues to increase, industry continues to respond seriously and expeditiously to environmental agendas.

Proposition 1: The Shift in Power to the Developing World

We don’t need to labour the point here. You all know that there is a vast shift in relative power to the developing world taking place. In the process, we are seeing a new world order slowly emerging around four capitals responsible for what one might call ‘civilisation states’ – super-states.  Consider the following:

America: It could have been 50 independent States, but instead it is the United States with power focussed around Washington, representing, if you will, a North American ‘civilisation state’.

China: Equally, had history over the past 2000 years taken a different form, it might have been a series of large States in China – Sichuan Province has about the same number of people as Germany. But instead we have a great Chinese civilisation state centred on Beijing.

India: You can tell a similar story about the great Indian civilisation state, centred on New Delhi. In dairy, for example, the State of Uttar Pradesh (some 170 million people) produces the same amount of dairy products (17 million tonnes in whole milk equivalent terms) as NZ.

Europe: The fourth ‘civilisation state’ is the EU – some 27 Member States including some very important economies such as Germany, France, UK and Italy. It is not a European civilisation state in the same relatively unified form as the other three (it is not yet and possibly never will be the United States of Europe) but in trade policy the Commission in Brussels has complete and effective competence and therefore we deal with Brussels.

A very simple proposition follows: if NZ, a tiny sovereign state, can do a deal with each of these capitals, we have covered a vast proportion of economic wealth and power. We are on the road, as we will see when I turn to Proposition 2.

Secondly, underneath these four super ‘civilisation states’ are some huge emerging economic powers – Russia, Brazil, Indonesia – along with some comparable economies that have been developed for decades – notably Japan, still the third economy in the world and Korea. We need, as a trading nation, to have adequate policy and commercial platforms in place with these important countries too.

Third, Australia is fundamental to our future. An economy now well over US$1.2 trillion, we are inexorably bound up in their future. Fortunately, their prospects are outstanding and their strategic thrust into the Asia Pacific region is entirely consistent with our own long-term trajectory.

The implications for the above developments are already obvious for dairy. About two-thirds of our dairy exports go to Australia and the Asia Pacific. China, which absorbed 5% of our dairy exports in 2000, now absorbs 20% by volume.

Finally, as this process of wealth creation – far from complete – takes place, the emerging economies are rethinking their view of food security. The phrase ‘food security’ sticks in my throat because for decades it has been used as the justification for massive protective barriers around markets – causing NZ huge economic damage and imposing considerable economic costs on the countries concerned through resource misallocation.

Today, we need to rethink the concept. Many of these countries will now depend on respectable food exporters like Australia and NZ for their future. In the case of China, for example, they have 23% of the world’s population, 9% of the world’s arable land, a huge and growing demand for high quality foodstuffs and major issues around water. This is creating space and opportunity for NZ.

Proposition 2: Trade Policy Gains

Again, I suspect for this audience the big picture here is well known. As NZ struggled to adjust to the new reality of our main export market – the UK – disappearing into the then protectionist morass of the pre-reform Common Agriculture Policy, a long process of trade policy reform began.

The first – and perhaps the most important breakthrough still – was the negotiation of the CER Agreement. I spent seven years of my professional life on bilateral economic relations with Australia and I can assure you that dairy was among the most difficult issues and was put on a slow track. 25 years on, the last symbolic obstacle to direct trade – the Australian ban on NZ apples – is being removed. The Australian Prime Minister made that abundantly clear in her historic speech to the NZ Parliament a few months ago.

This weekend, Prime Minister Key will lead a contingent of NZ Ministers and business leaders for the ANZ Partnership Forum where we are thinking of the next steps that need to be taken to enhance the Single Economic Market. In contrast to China and Taiwan – they talk of ‘one country, two systems’ – I think of this concept as ‘two countries, one economic system’.

The next breakthrough was the GATT Uruguay Round, which brought agriculture within a framework of international economic law. It fundamentally shaped the future of our dairy industry, principally because of the volumetric and expenditure based limitations on dairy export subsidies. The long-running saga of the WTO Doha Development Agenda continues.

Yet another attempt is being made by the Director General, Pascal Lamy, to find a way to bring the Round to a conclusion. As always, NZ will offer him strong support. I continue to take the view that whatever happens, sooner or later, the international community will have to take the development of the global system of trading rules forward. The Global Financial Crisis of 2009 showed overt protectionism is no longer viable – so intertwined are the world’s economies in the global supply chain. It is inconceivable that we have reached the end of the process of fashioning global trade rules.

If we step back from the current, deeply difficult, negotiations, I think the fundamental problem is that the great economic powers have not yet developed a close enough pattern of shared responsibility for the system they have inherited. In the Uruguay Round, it required the then dominant powers – the EU and the US – to get together in the famous ‘Blair House’ meeting and close the final gaps.

Today, precisely because of this vast shift in relative economic and therefore political power to the developing world, this would be impossible. No deal can be finessed without, at a minimum the key developing countries including China, India and Brazil, stepping up to the mark. A final deal still offers enormous possibilities for our dairy industry – including reductions of up to 80% in trade and production distorting subsidies and the certain elimination of all remaining export subsidies. I regret to say we just need to be patient still. We will never walk away.

Happily, NZ’s Trade ‘Plan B’, developed strategically out of CER in the mid 1990s and carried on by successive Governments, has carved out a far better future for dairy and NZ generally. In addition to completely free access to Australia, we are adding China, Hong Kong, and all the ten South East Economies to that network of opportunities as the respective FTAs phase their way in.

With respect to South East Asia, there are additional sweeteners in the form of FTAs with Singapore, Thailand and most recently, Malaysia. The most cursory examination of our dairy trade will reinforce the importance of these breakthroughs for your industry and the country as a whole.

Under negotiation is the next wave of FTAs – India, Korea, the GCC, Russia and most intriguingly, TPP or the Trans-Pacific Partnership Agreement, which is understandably focussed on the United States. We are continuing to talk about the longer-term possibility of a strategic economic partnership with the EU, though this is not up for negotiation for at least, say, the next two years. There are considerable difficulties to be overcome in all these negotiations – never expect plain sailing in trade negotiations.

However, if you step back you can see the pattern. Systematically, NZ is creating or trying to create excellent platforms for NZ trade with each of the capitals in the four ‘civilisation states’ I mentioned – Beijing, New Delhi, Washington and Brussels. In addition, we have negotiations either completed or underway with the next layer of power sovereign states – Indonesia through the CER/ASEAN deal, Korea and Russia. Missing elements are Japan and Brazil. We have ideas on both, but execution of those ideas will require cooperation with Australia and other partners.

In short, the dark days of NZ trade – hopelessly dependent on a Europe that was systematically pushing us out – are long gone. Powered by economic development on a scale the world has never seen and trade agreements to open the emerging markets, the future for trade is more promising than it has been for a hundred years when a technological breakthrough called refrigeration opened the trade door for NZ.

Proposition 3: Commodity Prices Trend Upwards

The Dairy NZ Strategy paper, jointly launched by Dairy NZ, the Prime Minister and Minister Carter in 2009, put the outlook bluntly:

“The 1960-2000 trend of declining dairy commodity prices reversed itself [in 2000] and trended upwards in real terms”.

I am aware of a proposition, long-established in economic theory, of the tendency for all prices to be commoditised. We may go back there. But for, say, the next ten years, it seems more plausible to see a continuation of this highly favourable trend.

Right now, the trend is on steroids. This week the ANZ Commodity Price Index was released. It showed we had reached new highs – and this covers a far broader group of commodity prices than dairy. Wool prices, thank heavens, are now double what they were 12 months ago.

This is not yet feeding strongly into the NZ economy. While it is uncomfortable that this is the case, the reasons why it is not yet feeding more strongly through the economy give us confidence in the sustainable future. Broadly, rural NZ is consolidating its balance sheet. So is Government and it must. The era of debt fuelled consumption is over. Everyone has to harden up. But this contains a promise of a more balanced sustainable growth pattern later on.

Two other points about price trends. First, at the risk of sounding like a cracked record – a metaphor that is bound to become incomprehensible to the digital natives now entering our secondary schools – we still need to cope with the challenge of volatility. I won’t repeat the reason. It should be obvious.

Second, the new normal – or at least the ‘new normal’ of rising commodity pricing for, say, the next ten years – has interesting implications for productivity.

In the 1960-2000 scenario of declining commodity prices was always, at least in my view, only half the story. I used to liken the gloom and doom of that period to hearing one hand clapping. It was all very well for the pessimists to point to the downward price trend; it was quite another matter to draw the conclusion that you would not want to produce a product that was on that declining curve.

The reason why that is so should have been obvious. Any producer of anything, whether a commodity or not, which is facing declining real prices can at least offset that price decline through continually higher productivity. Nowhere is the real price decline faster than in many IT products. However, that does not mean that economies like Taiwan that are in that business are in the wrong business. Quite the contrary – it all depends on that other curve – the trend towards higher productivity.

That is the story of NZ dairy 1960-2000 and why NZ dairy remained in business. The growth of total factor productivity (TFP) in agriculture generally was far faster than in the economy as a whole.

What does this mean for the future? Well, I think the answer is simple. If you, the dairy industry, can maintain the same pattern of annual average total factor productivity growth against the background, not of declining prices, but rising prices, you face an excellent future. Frankly, a single visit to a research institution such as LIC should persuade even the hardest sceptic of NZ agriculture that total factor productivity growth of around 2% is entirely plausible.

Finally, on this point, let me deal with another false choice before moving onto my real target, which is the false choice between increasing domestic production and strategic investment of our IP in dairy outside NZ. That is the false choice between supporting further growth of commodities and promoting high value, innovative exports.

It is time we put this canard finally to rest. The real choice we face in NZ is between the traded sector and the non-traded sector. By the trading sector I mean the efficient import competing sector as well as exports. But let me simplify the argument by just focussing on the export sector.

This Government is determined to proceed with its long-term objective of raising the share of exports to GDP by ten percentage points. This would, because of the link to higher productivity, confer enormous benefits on NZ including far higher real wages.

The choice is not between different types of exports but exports versus non-exports. Commodity trading, carried out by NZ’s hugely efficient agriculture companies, can be enormously profitable just as so-called ‘high value added’ products can add more cost than value. I have no doubt this will be accompanied by continual progress in innovative dairy products, food ingredients. That will, I hope, be matched by continuing success in the non-agriculture export sector. The choice is not between agriculture and non-agriculture exports. It is an ‘and’ proposition; not an ‘either/or’ proposition. Or trade policy will, I assure you, enthusiastically support all exporters of goods and services.

Proposition 4: Export the Product or the IP? A False Choice

I am an enthusiastic supporter of increasing dairy production in NZ and increasing our exports from that NZ production base. The corollary – reducing dairy’s environmental impact - is something I will come to in my final proposition about the future.

In Cabinet, this is not my responsibility. The Minister of Agriculture and other key Ministers have carriage of this, including the all-important matter of finding the right pathway forward on more efficient utilisation of the abundant rainfall that falls on our country.

What is clear to me as Trade Minister is that the market is there internationally to support this expansion. I remember saying to the Prime Minister as we returned from the extraordinary Climate Change meeting in Copenhagen that if he or anyone had asked me 20 years ago whether I thought it a good idea to irrigate in order to grow our domestic production base, I would have looked at them quizzically – to put it mildly.

My answer would have been: ‘why on earth would you want to do that? We can’t even sell the dairy and other agriculture export surplus we have profitably. The markets don’t exist at a profitable level’.

Well, twenty years on, the huge positive developments I have been describing change that judgement completely. I am therefore a strong supporter of further growth of NZ exports of dairy from our production base.

To put this in quantitative terms, according to OECD/FAO data that I use, between 2000 and 2010 world production of dairy products has grown by an annual average rate of 2% and world trade by 3%. That 1% differential describes in aggregate a major opportunity.

However, it would be naïve to imagine that only NZ will respond to the opportunity. We will face new competition. Let me focus on a country that I suspect is the last country on your radar screen – but it is on the Government’s trade policy agenda.

That country is Belarus. Belarus is the major supplier of dairy products to Russia. But it is increasingly a force in world markets. Its share of world cheese is now 7%; Australia’s share is 9%. Its huge and growing SMP exports now stand at 80,000 tonnes – or one-third of US SMP exports. We have always considered the United States as a major force in world SMP markets.

Fortunately, we are now negotiating an FTA with Belarus – courtesy of our negotiation with Russia. One of the conditions in launching the FTA with Russia – this was done by Prime Minister Key and Russian President Medvedev last November at APEC in Japan – was that we would also agree to include Russia’s customs unions partners. This aspect of the negotiation could turn out to be very interesting. Who knows where our future dairy partners will lie.

So we will face new export competitors – including countries we have never considered part of our competition. But the real challenge is not with new exporters but with the certain expansion of domestic dairy production in our key emerging markets.

Start with the most obvious country: China. In 2000, total milk production in China was nowhere near NZ’s – perhaps a third. In 2009, total milk production in China was 25 million tonnes of whole milk equivalent (WME). This is way above NZ’s current production of 17 MT of WME. The OECD/FAO projections for the next ten years are explosive – projected annual average growth in Chinese production of 7.6%

Let me put the proposition crudely. There is zero possibility of NZ supplying China’s future consumption needs in milk. Zero. Nada. Someone is going to profit from this. I would like to imagine it might, at least in small part, be us.

A similar point can be made about any number of markets but the five large markets that stand out, for different strategic investments are Australia, where Fonterra is already well established with such investments, the United States, where Fonterra is the largest exporter of US milk, Brazil, China, and India.

This will be challenging. NZ, both in agriculture and non-agriculture, has a generally poor record of investing overseas, although there are some stand-out successes. All I am saying is the following:

We have vast wealth locked up in our Intellectual Property in dairying – and not just at the production, or ‘gumboot’ level.

As consumption of dairy grows, we will be able to increase our exports, but there is no possibility of our feeding the Asian middle class: production will soar in some of these markets.

At the very least, we should aim to be part of that growth. The idea that there is a choice between supplying the market from NZ or investment has been completely overtaken by events. We can and should do both. I have never understood the phrase ‘you can’t have your cake and eat it too’. What’s the point of having a cake if you can’t eat it?

Proposition 5: Dairy Must Reduce its Environmental Impact

Finally, a vital corollary of supporting the further growth of dairy production in NZ is to support a policy of continual improvement in terms of dairy’s environmental impact.

I am not going to get into the policy levers here, because this is not my responsibility. It is primarily the industry’s responsibility. In a country that has a particular problem with Tall Poppies – a cultural trait that rarely serves us well, in my opinion – there is no escaping this reality. With dairy’s economic power, comes public expectations and therefore responsibilities. Obviously, it is so much better if this drive to respond to the environmental agenda is led by the industry.

I do not feel the slightest nervous or uncertain in saying this to you. At least with respect to your industry’s leadership I know I am speaking to the converted. I have noted carefully the positive and ambitious objectives set out in Dairy NZ Ten Year Strategy with respect to, for example, nutrient management plans, effluent non-compliance, mitigation technologies.

The one role I have played here, wearing my hat as International Climate Change Negotiations Minister, is to help launch politically the Global Research Alliance on agriculture emissions. The central purpose of the Alliance – which I believe will be finally and successfully launched in the FAO meeting in a few months time – is to explore over the long term mitigation technologies. We obviously hope that many of those mitigation technologies will have powerful environmental co-benefits.

Conclusion

The general conclusion is, I think, obvious. Dairying is going to be vital to NZ’s future and central to our export future. The opportunities are fantastic compared with the acutely difficult past we faced from 1973 to say, the mid 1990s.

But execution of successful commercial strategies to take advantage of these superior opportunities is still before us. You have a Government that is strongly committed to all exporters and deeply believes in our future as an agricultural exporter. In trade policy, no issue looms larger than dairy. Let us hope that the industry and Government can develop smart strategies equal to the occasion.