Concluding analysis on NZ Agricultural Debt, June 2009

Concluding analysis on NZ Agricultural Debt, June 2009

This month’s analysis should complete a picture of debt in NZ agriculture. The picture has been painted, the data is solid, and both are out in the open. Some institutions are still in denial, but that is only a matter of time.

We would like to move on and in future concentrate more on:

• a) Looking at the issue of profitability i.e. presuming debt is no longer an issue and
• b) The culture underlying both agriculture’s excessive debt and low profitability.

Profitability has been the primary objective of this site. Changing culture was not a direct objective but is critical to achieving the former, and if there is to be sustainable agriculture in NZ i.e. if we are to avoid a repeat of farming for asset gains.

Achieving profitable and/or sustainable agriculture would appear to require first understanding the availability, contestability and control of information and ideas within NZ.

In summary, culture and profitability aside:

1. Debt is a problem throughout NZ agriculture, but at the farm level it is still highly concentrated.
2. Where that farm debt is highly concentrated e.g. at least 20% of NZ’s dairy farm production - it is such that farms can not, and will not ever, meet their debt servicing commitments even under the most promising payout and interest rate scenarios. This is NZ’s equivalent to US subprime lending: reliant on continuing asset gains as income was never going to meet debt-servicing commitments.
3. The issue is building as its destructiveness compounds along with the debt. The real questions are as to the detonator, the timing and how well the consequences are handled.

The distribution of agrucultural debt is well illustrated by the following graph of dairy farm debt by debt quintile. Quintiles represent milk solids production, not numbers of farms.

The implications of this debt to the broader economy are more fully covered here: The Implications of Agriculture's Debt

Despite denial in some quarters, agricultural debt is now visible as a major problem. The media is becoming aware of the scale of agricultural borrowing particularly in relation to industry profit, and the RBNZ – in possession of the country’s best source of financial data - has focused considerable effort on the subject in its last three Financial Stability Reports (FSRs). Detail in those reports is essential to fully understanding the depth of the problem. The May 2009 FSR and others are available here: RBNZ Financial Stability Reports

Reading FSR’s takes time and is not for the faint hearted. Central banks won’t usually call a spade a spade, and the last report at least is more interesting digested from bottom to top. The following are extracts relevant to agriculture from the May 2009 FSR with some interpretation and analysis that together may provide an alternative to reading the full report.

Section 6.3 Rural exposures in Basel II

During 2007 and 2008, the Reserve Bank accredited the four largest banks in New Zealand to use internal models for credit and operational risk, as the basis for calculating their minimum regulatory capital requirements under Basel II. Among other conditions, the accreditation decisions required the banks concerned to improve their modeling of credit risks for farm lending, focusing in particular on key downturn loss given default (LGD) inputs. Given the commonality of the key risk drivers between banks, the Reserve Bank undertook to lead modelling work on risks in farm lending.

The Reserve Bank has now completed its initial work and has discussed the capital implications with the ‘internal modelling’ banks. In the Reserve Bank’s view, the banks’ models are not currently generating sufficient capital requirements for two main reasons. First, they do not take sufficient account of the risk of a sharp fall in farm land prices. Second, the internal model framework incorporates an overly optimistic view of the extent that risks in the sector can be diversified.

To address these concerns the Reserve Bank proposes to amend the relevant bank capital adequacy framework in the following respects.
• Specifying a minimum set of downturn LGDs differentiated by loan to valuation ratio. These will be higher than those banks are currently using; and
• applying the standard corporate default correlation coefficient to farm loans. This will reduce assumed diversification benefits, consistent with the characteristics of the farming sector in New Zealand.

The Bank will formally consult with banks on the detail of these proposals, and the timing of their introduction, in the near future.

This didn’t make headlines but deserves to. In here we see both a major contributor to the farm asset bubble (bank’s under rating risks in farm lending resulting in high profits and excess lending) and clear indications that this will not continue much longer. Land prices have already fallen sharply, and this says that banks will not in future be providing credit to fuel farm asset appreciation.

This action was needed years ago. It should reduce the scale of lending to agriculture when introduced, and improve finacial stability, but the transition could be traumatic - the current problem of farms with negative equity will still need to be addressed.

Section 3 New Zealand’s economy and financial markets

Agricultural debt levels have risen sharply and may not be sustainable…
Leverage in New Zealand’s agricultural sector remains high following rapid growth in borrowing in recent years as commodity prices increased sharply, pushing up rural land prices. Bank lending to the sector more than doubled in dollar value between 2003 and 2008, and continues to grow more strongly than lending to other parts of the economy (see Box C in Chapter 4), although growth rates have eased in recent months. Loans to agriculture currently account for 15 percent of total bank lending in New Zealand, up from around 10 percent earlier this decade. Rising agricultural debt has been accompanied by a trend increase in farmers’ debt-to-earnings and debt-servicing ratios.

As noted in the May 2008 Report, the distribution of agricultural debt is highly skewed across the sector, with indebtedness generally greatest among dairy farms (figure 3.18), especially new entrants to the industry and farms that have expanded through leveraged land purchases in recent years. Fluctuations in rural incomes, which influence land prices and lending growth with varying lags, are a key source of risk to both borrowers and lenders in the sector.

Dairy farms appear most at risk…
Although some segments of the agricultural sector (such as horticulture) are faring relatively well, other segments have faced some weakening in international prices, including the meat and wool sector. However, the effect has been buffered by the decline in the value of the New Zealand dollar over the past year (figure 3.19). Returns in the dairy sector have fallen sharply, with world dairy prices down nearly 60 percent from their November 2007 peak, returning to 2006 levels. The depreciation of the New Zealand dollar initially provided some offset to falling world dairy prices, but this has been limited by the rebound in the exchange rate in recent months. Despite some recent brighter indications for world dairy prices, the prospect of lower returns persisting beyond the current season remains.

…especially if commodity prices continue to decline.
These risks have become more pronounced recently as lower commodity prices and weakness in the world economy have reduced export receipts. Rural land prices appear to have eased after a period of significant increase, with a considerable drop in sales volumes potentially reflecting a widening gap between buyers and sellers. This may foreshadow a significant fall in land prices. Lower interest rates are easing the strain on farmers’ balance sheets, although debt-servicing burdens are unlikely to have fallen to the same extent as the OCR, given pressures on banks’ funding costs and adjustments to risk margins undertaken in response to weaker conditions in parts of the agricultural sector. In some cases, farms may use derivative products to fix interest rates on their borrowing, and these will delay the impact of declining interest rates on debt servicing costs. Moreover, input costs increased strongly in the year to December, although lower fuel prices are now providing some relief. The lower New Zealand dollar is also placing upward pressure on input and capital equipment costs.

...as lower payouts from Fonterra lead to a sharp reduction in budgeted revenues.
Reflecting these developments, Fonterra is currently forecasting a payout for the 2008/09 season of $5.20 per kilogram of milk solids (figure 3.20). While in nominal terms this payout remains high by historic standards, in real terms it has fallen to around its long term average, and constitutes a significant reduction in budgeted farm revenue. Lower payouts are affecting farmers’ cash flows and some farms have been forced to rely more heavily on credit lines and overdraft facilities earlier in the season than usual. Some farmers have ample headroom to increase debt if required, while others should be able to cut operating costs to reduce borrowing needs. As a general rule, ‘family farms’ are better placed to cut costs than larger corporate farms with more rigid wage structures. In aggregate, however, the agricultural sector’s vulnerability to a further tightening in the availability of credit or renewed weakness in returns appears to have increased.

The RBNZ is not known for scaring the horses but still clearly conveys the message that there are many issues facing agriculture. Others would have us believe it has never been a better time to buy a farm. Who do you want to believe – those with the best data or those with the most vested interests?

The RBNZ may be working to a form of displacement psychology. They appear more able to be open about risk, removing distressed assets and unsustainable debt when discussing other countries' difficulties. Given a) recent trends in currency, commodity and farm prices and b) the preceding commentary, the following extracts selected from the RBNZ's section on the international environment take on additional relevance.

Section 2 View of the International Environment

A pervasive feedback loop has emerged between strains in the financial sector and weakness in the real economy, which will be resolved only through concerted efforts to remove distressed assets from bank balance sheets. Some policy measures have been announced in this regard, notably in the US, but overall progress has been relatively slow thus far.

If realised, these forecasts would, by some measures, constitute the deepest global recession in the post-War era. Given that recessions combined with financial crisis are typically deeper and more protracted than in ‘typical’ cycles, global growth seems likely to remain below trend for an extended period.

Once asset prices started to decline, however, high debt burdens were revealed to be unsustainable, especially as subdued economic activity began to limit income growth.

Although caution is warranted in the current climate, it is important that New Zealand’s banks and other lenders continue to lend to fundamentally creditworthy households and businesses.

Rising agricultural debt has been accompanied by a trend increase in farmers’ debt-to-earnings and debt-servicing ratios.

There is cold comfort for NZ agriculture and banks in the following extract from the RBNZ’s overview:

Section 1 Overview

With the domestic economy expected to remain weak over coming quarters, asset impairments will continue to rise. Banks should ensure that they make adequate provisions and maintain capital levels sufficient to absorb unexpected losses. Exposures to the agricultural and commercial property sectors warrant particular attention.

There are few reasons to question the sentiments of the RBNZ. While conservative they do appear to reflect an understanding of agricultural debt and its consequences. It is not so clear if the RBNZ understands the cultural issues involved, or future world demand for agricultural commodities.

The agricultural asset bubble is clearly deflating, and it may be a very long time if ever before it reflates. The bubble may not burst but rather continue to deflate over many years. Circumstances though appear to be against that scenario.

Arguments can be made that past circumstances where large numbers of farms were expected to fail did not play out that way e.g. during the reforms of the 1980’s. While that is true of those circumstances, this time several factors count against that outcome. Differences include:

1. In all previous instances where NZ agriculture was forced to restructure the potential existed to increase farm production and profit. This time production generally already exceeds the point where MC=MR. Increasing production will in most cases reduce profit. Farming your way out i.e. producing more, is not a viable option. While scope exists to improve farm profit from better resource use (generally lower inputs), this does not similtaneously expand the wider economy or increase asset values in the way increasing production once could.
2. Indebtness is greater, assets more overvalued, and interest cover lower than they have been previously.
3. Costs are higher than ever with a greater perecentage non-tradeable and beyond the control of farmers. Margins are simply not there to service high levels of debt.
4. A major correction has been overdue for some years but was delayed and made worse by the commodities boom of 2007-2008. That correction is now taking place but this time in conjunction with a major global recession or depression - world consumption is falling.
5. The circumstances of restructuring this time are global – the usual NZ option of devaluing currency and living standards against better performing trading partners will not be effective.
6. Capital, leadership and ideas are scarce and NZ's farming culture is very different to what it used to be.

What will broadley happen is inevitable irrespective of changing commodity prices or interest rates. The question turns to who or what triggers that correction, and how damaging the process may be. Triggers may be any of the following, or more likely some combination:

1. Failures of leadership: Industry, regulators, government or Fonterra.
2. A lack of capital – either through high cost, restricted availability or regulation of lending
3. Collapse of confidence – through lack of world demand, culture conflicts or failure of industry icons (e.g. SCF, Agresearch, PGW, Fonterra)
4. Creditors force receiverships
5. Farm asset values collapse
6. Dairy farmers - individuals or equity providers - walk away
7. Financial institution failures

The RBNZ, financial institutions and farmers have serious decisions to work through. Unfortunately hampered by a lack of adequate market and economic analysis.

While debt is on the face of it only a major issue for a minority of farms, the scale of the problem is major and the repercussions flow into industry problems. Farm failures impact banks' viability and therefore ability to provide capital. All farms - irrespective of their own debt - are affected by the debt levels of processors and other providers of services to agriculture. Debt impacts industry costs and competitiveness.

Questions are whether the necessary cultural changes will follow, or new leadership emerge.