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IPIM Sept 2009 - Risk and Sound Decisions


This article is as submitted - an edited version was first published in The Official Journal of the New Zealand Institute of Primary Industry Management Incorporated: Vol 13 No 3 September 2009 ISSN 1174-524X
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  1. Contents
  2. Introduction
  3. The World
  4. New Zealand
  5. New Zealand Agriculture
  6. The New Zealand Dairy Industry
  7. Individual New Zealand Dairy Farms
  8. Risk Management


For at least the last two decades our prevailing mix of culture, politics and economics has led to poor allocation of many of the worlds resources.

In the process many of our values and decisions became distorted.

We expected more, and in turn were promised more than was sustainable.

We were encouraged to think of ourselves as special – even uniquely special.

Individually and collectively we have made mistakes, and it is now time to pay the piper.

This article may make uncomfortable reading for some, but it is intended to make people recognise an uncomfortable reality.

To make sound decisions about risk you need to think for yourself and make your own assessments from as broad an understanding of your environment as possible. The main alternative to sound decisions – the lazy one - is to follow the herd. This article is intended to provide some balance to what has been the pervading neo-classical economic view of the world i.e. ongoing economic growth driven by credit (effectively consumption of future production) managed by central bank economists under government direction delivering what we aspire to.

The World

The world is not comfortable accepting the fact, but we are entering a depression. A depression is the unavoidable correction to a prolonged cycle of expansion of credit to fund consumption. Funding consumption beyond production has been the cultural-political choice of society. The current cycle of credit expansion has existed since the Second World War in most Western economies. In essence it has the same characteristics as the cycle of 1874, and earlier ones. But of course we believe this one will be different because as a culture we are now so much smarter.

The current cycle of expansion started after WWII and was initially relatively benign – the world had lower population and much greater potential for real growth. The last twenty years have been the opposite requiring more effort and more extreme measures to keep credit expansion going and maintain perceptions of ongoing growth. The last ten years have been even more so.

We are looking at a cultural phenomenon – a cultural-political interaction that takes place without significant intelligent and reflective philosophical input. Economics fails to deliver the promised cultural-political requirements for real growth but provides instead complex models of increasing notional wealth. The mathematics of compounding wealth remain pervasive and offended. In time what passes for science and technology becomes similarly affected.

The inevitability of a depression is the outcome of compounding debt. A point comes where the debt can no longer be serviced. Markets then lose confidence and asset bubbles start to unravel as markets become unwilling to take on more debt.

There has been stimulus and expansion of credit through governments taking on debt normal markets are unwilling or unable to take on. How situations of excessive total debt are to be remedied by additional government debt is unexplained. It has never worked before. The movement of private debt to collective debt is also making options to repudiate debt less tenable.

A contraction in money supply and credit is occurring – the correct definition of deflation. This is delivering the required contraction in asset values and should lead to a repudiation of much debt.

Instead we have government and central bank efforts to preserve debt, inspire confidence and re-inflate asset values. This is very much about defending privilege and expected future privileges.

Economics and economists – especially the neo-classical – are being very accommodating. But they are yet to adequately explain how wealth can continue to compound, or why it should. How growth can be sustainable or why we need growth other than to support compounding wealth. How inflation can increase the stock of capital, or how excessive levels of debt can be solved with governments taking on even more debt.

Non-economists are becoming less accommodating. The credit driven growth model is increasingly being regarded as one of a number of models that are failing or have already failed. There is declining tolerance of, and widespread anger at: Any socialisation of private debt; Financial and accounting fraud and; Political corruption.

There is a possibility we will only have a recession. I hope not. If we only have a recession we will then return to a weak credit expansion cycle saddled with additional government debt from the stimulus packages. The required structural and cultural changes will not have been made. The required deflation of asset values relative to incomes will only have been postponed.

New Zealand

On a per capita basis New Zealand has been a top participator in the worldwide expansion of credit. Only Iceland did better. The last time we had a monthly current account surplus was in 1973. Most people currently living in New Zealand have never been here in a month where the country paid its bills without increasing its borrowings.

We have a long history of debasing our currency in real and relative terms. This has lowered our living standards relative to the rest of the world. We have compensated by borrowing to live beyond our means. Our collective debts have such a large foreign component that we no longer have an option to manipulate our currency down. We require an alternative means of lowering living standards, but government is not prepared to overtly lower wage rates.

New Zealand entered a recession in the first quarter of 2008. Lehman Brother’s collapsed in September 2008. Trends in expansion of money supply and credit reversed from October 2008. Money Supply (M3) is reducing faster than total claims implying an increased percentage of borrowing is coming from offshore.

Why is M3 decreasing? Aren’t we saving more? That is not clear. We are working fewer hours, and commodity prices are down. We are not consuming as much. Where possible we are reducing debt. Those reliant on interest from savings are getting lower returns and are therefore eating into their capital - as are many others - just to survive. Tax from this source is also down. Many of those paying reduced interest are unlikely to be liable for increased taxable income (homeowners and farmers at least) from the lower interest rates.

Figure 1. New Zealand Credit and Money Supply.

Figure 1 shows some of the trends in money supply and credit. Over the twenty years to October 2008 growth in credit was exponential getting to about $2 billion per month before dramatically changing to an average contraction. Despite stimulus from tax cuts, a very low OCR, a limited amount of quantitative easing and a constant barrage of confidence boosting news from banks and government agencies.

For the first seven months of this year government has been borrowing at a rate of $200 million per week - $10.4 billion annually. The suspicion is that this rate is likely to increase.

Term interest rates are expected to increase steeply over the next year (9-10% for housing, more for business and riskier assets) despite anything the RBNZ may do with the OCR.

Productivity over the long term is a problem we recognize. Why we have a problem with productivity may not be so accepted.

We get a consistent message from the OECD. A selection of statements regarding R&D follows from ‘The Sources of Economic Growth in the OECD Countries – OECD 2003 Summary and Policy Conclusions’:

The results also point to a marked positive effect of business-sector R&D, while the analysis could find no clear-cut relationship between public R&D activities and growth, at least in the short term.

One reason why pro-competitive regulations help growth is because they promote innovation.

Many OECD governments also encourage R&D and innovation in the private sector by using grants, subsidies, loans and tax credits.

Furthermore, regressions including separate variables for business-performed R&D and that
performed by other institutions (mainly public research institutes) suggest that it is the former that drives the positive association between total R&D intensity and output growth.

The negative results for public R&D are surprising and deserve some qualification. Taken at face value they suggest publicly-performed R&D crowds out resources that could be alternatively used by the private sector, including private R&D. There is some evidence of this effect in studies that have looked in detail at the role of different forms of R&D and the interaction between them.

In 2006 Treasury came to similar conclusions regards New Zealand’s public sector R&D:
Julia Hall and Grant M Scobie, 2006. The Role of R&D in Productivity Growth: The Case of Agriculture in New Zealand: 1927 to 2001:

An advanced ability to filter out information we don’t want to know should perhaps be added high on our list of issues to address. Together with a tax system that distorts investment decisions and principal-agency problems (managerial capitalism).

New Zealand Agriculture

To understand NZ agriculture you have to come to grips with its underlying culture. Our agriculture provides a great example and clues as to why our level playing fields and best practice systems have delivered average or below results.

The culture includes a consistent message from the research and advisory sectors regards increasing the volume of production and the bright future of New Zealand agriculture provided capital continues to be injected. In summary: Defend the status quo; Keep clipping the funding ticket and: Suck in as much other money as possible.

The Douglas/Treasury model of agriculture put in place in the 1980’s was one of perfect markets. Government became hands off. That helped for a while but the model lacked a centre of intelligence to ensure the integrity of the system.

New Zealand agriculture’s medium term future was effectively defined late in 1999 when Clark/Cullen modified the Douglas/Treasury model and approved the formation of Fonterra - together with increasing the RBNZ’s policy target for inflation to 1-3%. These were political decision whose consequences were understood. Most of those consequences have come to pass or are in the process of doing so.

A farm asset bubble was guaranteed. This bubble spilled over into the residential housing market.
Dairy farming was dominating all agriculture and distorted costs and asset values for other producers. Inflation particularly of non-tradeable costs had been assured but was largely ignored. Operating costs did not appear particularly relevant to owners, regulators or government in the light of rapid inflation of farm assets.

Increasing production at low or negative marginal return was confused with farm productivity but was used to justify a rapid rise in farm asset values. Agriculture appeared blinded by its notional success and provided little innovation, poor returns to public R&D and low productivity gains. Agribusiness thinking provided academic support to the business of farming for capital gains.

The farm asset bubble has now burst. Asset values are down 30-40%, or to 20% below 2006 values. There is currently no market for farms – rural real estate agencies have few buyers. The money available to purchase farms is negligible, and overseas buyers non-existent. Banks are not making finance available – some being so blunt as to explain there will be no new lending except where interest is being capitalised.

Agricultural debt currently exceeds 400% of agricultural GDP and is still increasing at $13 million per day ($4.8 billion pa) from $46 billion at the end of June 2009. This debt marks a steadily rising percentage of NZ lending as most other sectors of the economy de-leverage. The trends are clear from Figure 2.

Figure 2. Trends in New Zealand Agriculture’s Debt.

Debt is agriculture’s most immediate problem, and may flow on to seriously impact those who have provided finance to agriculture. But the farm asset bubble must deflate if NZ agriculture is to have a viable future. This is helped by farm values being assessed on farm profitability.

An increasing number of farms are under bank management, and a large number will be sold over the next year. Interest rates have dropped, but are expected to start rising again. Risk premiums will also be much higher.

Why have our level playing fields and best practice agricultural systems delivered a highly indebted industry for the most part struggling to make reasonable profits? I am not going to try and answer, but will instead offer a mix of ideas accepted in agriculture over the last two decades or more before commenting in passing:
· In 1986 some in the agribusiness community were advising farmers to diversify away from farming by investing in the share market.
· By 1998 it was commonly accepted by those trading farms that any returns from farming would be from asset appreciation and not profit
· 2000 saw the dairy industry accept a mega co-op model against the better judgement of regulators but with the Dairy Industry Restructuring Act ensuring easy access to milk supply for new entrants in high value manufacturing.
· NZ agriculture has always had booms and busts - sometimes multiple cycles are the order of the day: Kiwifruit, exports of kiwifruit plants, wool, deer, ostriches, fitches, forestry, nashi pears, persimmons, goats, dairy, grapes and aspects of biotechnology.
· About 2004Agresearch adopted as its vision doubling NZ agricultural production by 2020
· The ‘Golden Age of Agriculture’ became a common theme in 2007
· Early 2008 success in agribusiness was defined as convincing an aging but debt free dairy farmer to use the power of other people’s money and purchase a second dairy farm. The thinking was not new.
· 2008 also saw the then minister of agriculture touring NZ talking up investment in increasing dairy production.
· July 2009 saw farm asset values $30-40 billion shy of what they had been worth at their peak.
· August 2009 and Prime Minister John Key officially launches Food Innovation New Zealand at Massey's Manawatu campus. The key benefit to New Zealand is to be the value FINZ adds to our traditional primary produce with an ambition to increase total food and beverage export returns to more than $40 billion (from $22.9 billion, in less than 10 years).

In regards the last point I had thought that increase in exports had been an expectation of the mega co-op when it was approved. The launch of FINZ does appear to include a lot of spin from the usual network of collaborators. I can’t find substantive analysis to support the promised outcome, and there doesn’t appear to any questioning of past performance in delivering to similar expectations. I am skeptical. The opportunity to add value to dairy products through high value manufacturing within or outside of Fonterra has been available for a decade, but it didn’t happen. What is different this time?

Taking an allocation of resources, marketing, or return on investment perspective and looking at the full list of ideas above, I see the focus is still supply rather than demand driven and is about improving commodity volume or prices. The thinking hasn’t changed over time. Much of agriculture is still focused on attracting speculative investment money rather than making profits.

Close to the centre of the FINZ agri-food hub and providing a contrast is New Zealand Pharmaceuticals (NZP). They do add value to some food products but make their money manufacturing pharmaceuticals from animal byproducts. Profitably. They are not promising to add billions of dollars to existing New Zealand commodities – much of their raw material is imported.

NZP would provide a good contrast to FINZ when deciding whether Treasury and the OECD are correct in their conclusions on the relative values of public and private sector returns to R&D.

Where are the credible analytical and/or information bases on which the likes of FINZ make their decisions on investment in New Zealand agriculture?

In July 2009 MAF provided forecasts of farm incomes tripling over the next four years - in marked contrast to their 2,008 projections that were still optimistic but far more realistic.

Figure 3. MAF SONZAF - forecasts and estimates of sector income and debt servicing costs.

The rosy forecast was presented to the media by the Director General, but is only achieved by forecasting using a 0.52 NZD:USD through to 2013. Debt servicing costs are projected to more than halve over the period and make the biggest contribution to improving income projections. The 2009 forecast is available from MAF’s website.

There are three ways that the projected level of debt servicing could be achieved by 2013: Widespread default; Low (3%) interest rates or; Foreigners taking farm ownership. Combinations are possible. Any explanation of the analysis behind MAF’s forecast debt servicing costs would be welcome.

Opposing views exist on agriculture’s future. The incumbent view I will call Plan A. It has taken NZ to the situation it finds itself in now, encompasses all the major institutional players, and supports the industry culture earlier described. It is perhaps epitomised by the dairy industry’s 2009 strategy – more of the same. In that strategy debt only gets one mention in declaring that farm debt equity ratios have not changed since the 2004 strategy.

Plan A has a consistent message whose questioning is frowned upon. Public sector R&D and increasing agricultural production are revered. NZ agriculture has a positive future simply because we grow food. The world recession is to blame for most other ills. Plan A would prefer to deny that there could be a Plan B.

Plan B is an alternative view that lines up with the earlier selection of points from the OECD and will lead to greater competition and innovation. Its economics are resource rather than asset driven.

Plan B is pragmatic. Public sector R&D is crowding out innovation and returns to research.

The New Zealand Dairy Industry

The New Zealand dairy industry has not responded constructively to the threats and opportunities presented by the restructuring that occurred with the formation of Fonterra. Some of that as a consequence of the Dairy Industry Restructuring Act and the mega-co-operative model which dominates the industry. The industry has in addition bought into its own hype.

The industry - led by the agribusiness community - has concentrated on farm asset growth, but has performed poorly in terms of productivity and farm management. The following graph is commonly presented without the debt to: Show the gains made in dairying; Argue for more investment into R&D and; Imply the industry’s expansion strategy is delivering.

Figure 4. Dairy cow metrics including the average debt per cow rebased to 1994.

The debt adds another perspective. The graph shows increases between 1994 and 2008 of: Debt per cow: 408% (to $6,400 per cow); The dairy herd: 47% and; Milk production per cow:10% (to be fair this is under the long term average annual gain of 1%). The dislocation of debt per cow and milk production per cow is alarming.

At the moment debt defines the industry, but its distribution is fortunately is highly skewed. Dairy farm debt is causing banks considerable concern, and the free flow of money into the industry has dried up. Some dairy farmers are currently using their creditors as sources of finance.

Figure 5. Dairy debt for each debt production quintile.

Figure 5 suggests that total dairy farm debt is $28 billion, the distribution is highly skewed, and that where debt is concentrated it is compounding irrespective of good payout years. That 28 billion includes debt owed to bank and non-bank financial institutions surveyed on a monthly basis by the RBNZ. Additional debt exists.

Figure 6. Farm debt per cow, expenses, asset values and payout rebased to 1994.

From Figure 6 it is obvious that debt has grown much faster than asset values particularly since the formation of Fonterra. The dairy expenses index has risen in line with normal payouts. From June 2008 debt continues to compound while asset values and payout have crashed back to earth. Worse is probably still to come from falling asset values and this season’s payout being well below the $5.20 projected for the 2009 season.

Since the formation of Fonterra the objectives of the industry have merged with the objectives of Fonterra. The dairy industry strategy is effectively synonymous with Fonterra’s strategy.

Fonterra’s strategies have always been difficult to pinpoint with any precision making it particularly hard to assess their success. What has been apparent is that strategy has been in an ongoing state of flux. It is possible to infer the major phases as:
· Market power and efficiency from scale - Fonterra has undergone almost continuous restructuring.
· Growth - growth in what was never explained. In effect it was mostly about getting bigger through acquisitions.
· A shift to exploiting NZ dairy industry supply chain expertise by exporting it to other countries.
· Survival - the current situation. Long-term strategy has been replaced by short-term focus on remaining viable - effectively to access additional equity capital.

Individual New Zealand Dairy Farms

Many factors contribute to the value of a farm, but recent economic circumstances have changed much. The question of asset values may be from the perspective of whether the farm owner has positive equity, or alternatively at what value does purchase make a sound investment. Three main factors impact on the value: Profitability; Interest rates and; Any lifestyle premium. Lifestyle values only apply to some farms, and may not be bankable. That leaves profit as the main determinant of value followed by interest rates.

A disruptive consideration to farm values is the relationship of each farm’s value to that farm’s access to processing of raw milk product. Fonterra’s formation caused a major upward revaluation of that access. The process is now working in reverse.

The present value of a farm is derived from the stream of income it generates over time. The value of this income stream is influenced by the discount rate – effectively the cost of finance.

Figure 7. The effect of payout and interest rates on Waikato dairy farm present values at 2009 costs.

The impact of interest rates on present values is clearly very significant.

What influences farm profitability?
· The revenue the processor receives, and the split between the processor and the producer. A producer co-operative is there to maximize the amount of that revenue going to the producer.

· Costs. While revenue varies, costs are stickier and should be a far more important influence on asset values. Finance costs are often a farm’s major cost, but vary widely depending on debt. Operating costs are though more insidious. At the moment these should be receiving a lot of attention from the perspective of farm viability, but also to maintain asset values.

Figure 8. The impact of increased operating costs on farm present values between 2007 and 2009.

Operating costs have a major influence on farm present values. To the extent that eventually increasing costs could mean a farm has no productive value i.e. you can’t make a profit even if the farm is free. This fact seems to be lost on both local and central government.

We come at this point to conclude that dairy farmers don’t in the short term have any control over payout, and no control over some (non-tradeable) costs. We find we are back to considering many of the basics that concentrated farmers minds from the 1950’s to the 1980’s – the almost forgotten art of how to select the production system and level of production that maximises farm operating surplus.

This is where the best financial return to farmers for effort is to be found - provided managers can get past a number of pre-conceived barriers. Work done for MAF policy in 2007 using a sophisticated bio-economic model identified national gains in dairy farm operating surplus of $250 million simply from selecting the correct stocking rate for the existing farm system.

The paper is available:

The concepts contained within that paper, and they go far beyond correct stocking rate, are now critical. With the low payout expected for the current season, knowledge of that work and its application will be the difference between some farms surviving or not.

The concept of producing to where marginal cost equals marginal revenue is still poorly understood in agriculture. This blind spot is the cause of poor farm financial performance, and also for high externalities.

Concepts of marginal costs and revenue must predominate over the current mantra of more production and holding external factors such as markets, exchange rates, tariffs or subsidies responsible for poor on farm profit performance.

Every accountant, farm consultant, banker, land agent and most importantly each farmer needs at least to understand what their marginal costs look like.

The two graphs that follow are from the link above and should be considered as illustrating concepts. The data represented by the graphs is modeled with cows fed optimally and was precise for 2006, but we are now in 2009 and I don’t want specific detail to distract from the concepts being illustrated. In 2006 this farm typically had a herd size exceeding 300 cows. Reducing its herd size would have improved the farm’s operating surplus.

Figure 9. Marginal Operating surplus per Cow.

Marginal operating surplus per cow is the amount each additional cow in the herd individually contributes to farm operating surplus. Figure 9 shows that contribution switching from a positive contribution of $400 per cow to a negative impact of in excess of $400 per cow over a change in herd size of ten cows. Who wants to milk additional cows when each of them is costing $400, $600 or $800 in farm operating surplus? The correct herd size matters. The point to take is that in pastoral farming marginal operating surplus can change quickly and dramatically.

The correspondence of the switch from a positive contribution to operating surplus to a negative contribution with the introduction of purchased maize silage is no coincidence. It is pure cause and effect. Each additional cow makes a negative contribution to farm operating surplus. This conclusion is clear and precise for the combination of revenue and costs illustrated.

An alternative with even more drastic impacts on operating surplus is adding cows without also providing optimal levels of dry matter to feed them.

For the technically inclined, substitution of dry matter between silage made and pasture feed in situ moderates the negative impact on operating surplus of additional cows until such time as silage is no longer being made. Then the full negative impact of feeding additional cows is seen.

The second graph is for exactly the same farm, costs and production but presented in a different form i.e. in terms of costs per unit of production but also showing average costs, average revenue and farm operating surplus.

Figure 10. Marginal Operating Costs per Cow.

In Figure 10 operating surplus is maximized where marginal revenue equals marginal costs (MC=MR). Payout is a good proxy for marginal revenue. Therefore, at a $5.50 payout, operating surplus should be maximized where marginal cost equals $5.50 per Kg of milk solids. True. Average cost and revenue are changing, but neither can provide a clear indication of the level of production to maximize operating surplus. Beware averages!

Anyone advising dairy production who is not aware of, or who does not understand, the implications of producing beyond the point where marginal cost equals marginal revenue will be to some extent derelict in their duty.

Levels of debt for individual farms provide stark contrasts. It is clear from RBNZ data on the distribution of dairy farm debt that many farms have little or no debt while others have levels of debt that can never be repaid. The data is though complicated by sharemilking properties having two potential sources of debt – the farm owner and the sharemilker.

Figure 11. Average Debt per Production Debt Quintile.

The lines in Figure 11 plot quintile averages, and as such there will be considerable individual farm variation about them especially for the higher debt quintiles. Irrespective, the data is a stark illustration of the problem some dairy farms have with debt, and how the problem is compounding.

Those attempting to farm with debt levels in Quintile5 have almost certainly passed the point of no return. Debt levels are such that they can’t be serviced at any foreseeable combination of payout and interest rates meaning debt will only increase. In many cases the debt will need to be repudiated.

Debt should not be an issue for farms with debt in Quintiles 1 and 2 but access to new finance may be restricted and more costly than it would otherwise have been due to the finance industry’s current adverse attitude towards agriculture.

Prospects for farms with debt in Quintiles 3 and 4 will depend on the level of debt, the ownership structure, other sources of equity or income, and managerial ability in terms of maximizing the operating surplus that can be generated.

Risk Management

Risk management is not something that can be done after the event. The key times to have considered the risks to New Zealand agriculture were: First, during the Douglas/Treasury reforms of the 1980’s; Second, at the time the dairy industry moved to the mega co-op model and: Last, after it was made clear to first Treasury then MAF in 2006 and 2007 that agriculture’s dependence for viability on inflating asset values could not be sustained.

Despite it being too late in some cases to save farms, individuals can, and perhaps should:
1. Work towards acceptance of a very different environment from the past. In some cases responsibility for the situation a business finds itself in is personal. In others farmers have been badly misled - sometimes by systemic failures of their industry. Questions should be asked. There are two opposed perspectives on agriculture. Only one is right – sorting that out sooner rather than later is essential

2. Get involved. Attempt to bring about the industry changes below

3. Engage production economics - that will provide your best chance of a viable farm operation. Most importantly increased profitability will be reflected several fold in farm asset valuations

4. Be wary of the status quo being rehashed as change e.g. merged or renamed institutions with the same school of people in control.

Industry entoto is in much the same state as individual farmers, but with much greater need of fundamental change. While farmers individually are reasonably smart, their delegated decisions often are not:
1. Turn the industry ethos (production, privilege, and paying professionals to do their thinking) upside down. The main pillars of that ethos are Agresearch, DairyNZ and Fonterra.

2. NZ agriculture will not remain viable for long if any of the three pillars continue in any way recognisable as their current form. Central to reform will be changes to leadership.

3. Regulators, research and research funding are problems far bigger than agriculture, but possibly equally or more in need of drastic restructuring. In these cases there are though far more stakeholders involved.

4. Demand industry costs are reduced.

Individuals not farmers:
1. Wise up on production economics – otherwise you will remain part of the problem

2. Reflect before choosing one side of the fence

3. Question, analyse and challenge the existing ethos

4. Take care what you are seen to put your name to

Political and cultural leaders need to decide where they draw the line between their constituents and defending existing privilege. The latter, and especially any socialisation of private debt, will likely be judged harshly if not necessarily immediately.