Background: The New Zealand dairy industry The New Zealand dairy industry, which generated NZ$26bn exports in 2023, is the country’s largest export industry, contributing 25% of NZ merchandise exports. New Zealand is the global low-cost producer of dairy products. It also produces a product which is higher in Omega 3 fatty-acids and has a comparatively low GHG footprint¹ due to cows being pasture fed. As readers will be aware, dairy is a key ingredient in many vegetarian diets. Perhaps most excitingly, recent advances in ruminant biotechnology and genetics seem likely to enable complex (and hard to obtain) food proteins from this sector to be grown with a lower emission footprint than chicken or pork through the near elimination of methane emissions. It should be kept in mind that the “white proteins”, including dairy, already have approximately eight times lower emissions per calorie than red meat². The NZ dairy industry has achieved steady productivity growth, and benefited from inflation. Over the decade from 2014, these two factors have increased NZ dairy export revenues by 44%, from NZ$18bn to the $26bn mentioned above. However, due to policy changes, a large part of the cashflow gains over that period have been diverted to debt repayments, rather than re-invested in the industry and/or returned to landowners. This paper analyses why this has happened and explores the possibility of a policy change in New Zealand. Evolution of “Peak Cow” policies in New Zealand In the years from 2018, the Reserve Bank of New Zealand pioneered what Craigmore believes was a world-first policy experiment to restrict the flow of bank capital to a significant agricultural sector – NZ dairy farming. This policy was developed against a wider background of limiting the growth of land devoted to the dairy sector in New Zealand. The primary driver of what have become known as “Peak Cow” policies has been a desire to ameliorate the environmental footprints of dairy, particularly nutrient loss to water. The NZ dairy industry grew quickly, from 2.5 million cows in milk in 1990 to more than five million by 2015³. Over that period, land-use was converted from extensive (mostly sheep and beef) grazing and arable cropping to dairy, much with support of investment in centre-pivot irrigation. Nitrogen and other nutrient pollution of water-ways became an emotive issue. Many New Zealanders came to feel that the focus of the industry should move from increasing the acreage devoted to dairy, to improving the quality of production, with a particular focus on the industry’s environmental footprint. This focus has proved successful. Nitrogen use on dairy farms has reduced in response to a national cap on fertiliser use. As a result nutrient loss from the dairy industry to waterways is now generally reducing year on year. As the industry became New Zealand’s largest single sector, the Central Bank (the Reserve Bank of New Zealand or RBNZ) became concerned that, with some farmers having 60% or 70% LTV (with an average industry level less than 40%), debt in the dairy industry posed a systemic risk. Dairy farming in New Zealand generates unusually high cash ROA’s (as we will see 4% to 8% in the period under discussion, compared to e.g. 3% for other grazing systems). While these healthy cash flows are positive, there was a perception that they could lead to an over-reliance on bank leverage for growth. Changes in bank financing of New Zealand dairy farms In response to RNBZ concern, the New Zealand banks were disincentivised (via capital ratios and other rules imposed by the politically independent Reserve Bank) from lending to the dairy sector. Understandably, banks began to withdraw capital from the sector. Farmers in New Zealand had not traditionally been required to actively amortise debts; interest only borrowing was the norm. After 2018, many New Zealand dairy farms were required to amortise debt from free cashflow (as a priority over re-investment or shareholder dividends). This was the principal means by which the NZ banks withdrew capital from the sector, although there was also a reduction in lending to new borrowers. Noting, however, that farmers with moderate leverage such as Craigmore’s partnerships are not now having to ammortise debt, but are reducing it anyway, in the face of higher interest rates. Figure 1: New Zealand bank lending by agricultural sector from 2016 Source: RBNZ Restrictions on new lending and debt amortisation reduced the total balance of New Zealand bank lending to dairy farms from $41.6bn in July 2018 to $36.5bn in February 2024. This was a reduction of $5.2bn over the six-year period, representing a 12.5% reduction in debt balances (i.e. about 2% was paid off annually across the sector). As can be seen in the blue line in the graph above, the policies particularly targeted the dairy sector. Over the period, lending to other agriculture (green line) increased steadily. Within this total horticulture lending grew sharply, while sheep and beef financing flat-lined. A $5.2bn reduction in NZ dairy industry debt during six years is $850m per year, a substantial withdrawal of capital from the sector. Furthermore this number may understate the “counter-factual” of what would have happened if policy settings had remained unchanged. In that instance, per hectare debt levels and industry investment would have been expected to have grown by e.g. $1bn per annum (a significantly slower growth rate than industry revenues), rather than shrinking by almost $1bn per year. To be clear, industry debt reduction is not inherently negative. It reduced debt exposure at a valuable time ahead of recent rises in interest rates. This bodes well for the future of the industry. However, what is clear is that if the sector had received around $1bn a year of additional bank lending (as would have been expected for a significant and strongly cash-generative sector), as opposed to having to find $850m per annum of bank debt repayments, dairy land prices would be expected to have been significantly more buoyant over the period. OIO rule changes also restricted capital flows to New Zealand land Over roughly the same period, from the change of government in late 2017, the New Zealand government also significantly tightened the ability of non-Kiwi investors (such as Craigmore managed partnerships) to acquire NZ farmland. Craigmore estimates that, in the period before 2016, this source of capital brought an average of about $200m per annum into the New Zealand dairy industry. Although important, we estimate the impact of the bank lending changes may have been as much as 10 times greater than those restricting the deployment of foreign equity capital. This stands to reason. Every New Zealand farmer knows that the marginal buyer of land is one’s neighbour, armed with equity from his or her capital gains, supported by bank debt. It is a rare NZ farm purchase that is made other than by a domestic New Zealand farmer. However, it is worth noting that the withdrawal from the market of the overseas buyer may have had a disproportionately greater impact, as support from sophisticated international investors such as international pension funds, provided an important and consistent psychological underpinning of the market. The impact of policy changes Changes in NZ capital regulatory settings, coincident with OIO changes, have had a profound impact on dairy land valuations. Productivity and farm-gate prices improved over the period. However, these improvements were not capitalised into land prices, as would normally have been anticipated. Instead, average operational yields from NZ dairy farms increased from just under 4% in the four years to 2020, to over 7% in the following four years. Figure 2: New Zealand Dairy Industry Average Return on Asset Source: Dairy NZ Economic Survey Depreciation is assumed at 1%. FY2024 forecast based on current season milk price and costs. Better farms, such as those in the Craigmore Canterbury dairy farm portfolio, are now yielding closer to 8.5% (before fees, interest and taxes)4. This increase in cap rates represents a significant downward adjustment of real land prices. In order to reverse it dairy land prices would need to rise by 40%. Implications for Craigmore investors Craigmore anticipates that dairy sector land valuations will eventually capitalise the inflation and productivity gains achieved over this period. This capitalisation of net farm income into the value of the underlying land is ‘normal’ for farmland around the world, and has also been the case historically for New Zealand farmland. Productivity and profitability gains over the period were significant. For instance, EBITDA per hectare of Craigmore’s Farming Partnership increased substantially, rising from $1,650 per hectare to over $3,300 over the past five seasons, as illustrated in the graph below. Figure 3: Craigmore Farming Partnership Dairy EBITDA per hectare FY15 to FY23 Source: Craigmore National policy implications of the capital restrictions The NZ primary sector, and the dairy sector in particular, is becoming under-capitalised. At over 80% of merchandise exports5, the combined primary sectors remain New Zealand’s most important industry and dairy the largest individual sector. If not addressed, restrictions on capital flows and, effectively, long-term investment in the sector, can be expected to have a negative impact on the New Zealand economy. NZ farming also needs to be able to play its role in reversing a chronic current account deficit at over 7% of GDP, which has crept into the NZ economy since Covid. Figure 4: New Zealand Annual Current Account Balance to GDP Ratio Source: StatsNZ Further to this, farming, a capital intensive industry requiring regular flows of new capital in normal circumstances, now also needs investment capital in order to de-carbonise. At a more personal level, succession planning is also needed both for an increasingly old cohort of heroic figures, who built the modern New Zealand farming industry following the removal of farm subsidies in the early 1980s, some of whom now need to find a buyer (and a buyer that they can respect) for their beloved farms. Logically this should be to those hard working young farmers, who would like to buy farms (in some cases assisted with equity capital from organisations like Craigmore; or by their families), but who currently lack access to debt capital. Response of Craigmore and other farming groups Craigmore believes that, albeit gradually, the NZ political and policy leadership is coming to see that the policies adopted have now largely achieved their aims of environmental improvement and farm de-leveraging. They now need to be modified so that the NZ farming sector can have better access to both bank and international capital, to enable them to play their key role in the NZ economy and in further improvement of environmental footprints. In these contexts Craigmore and other farming groups, such as NZAB have repeatedly drawn attention to the need to evolve these policies. However, even so, we believe that some market participants and policy makers may not yet fully appreciate the impact of a ca. NZ$2bn per year liquidity shortfall experienced by the dairy sector, and the economy-wide negative implications of this. Craigmore and other leading farmers are trying to stimulate constructive debate, so a sensible way forward can be defined, which enables the capital market in land to function more effectively, while at the same time ensuring that environmental progress continues. Recent comments from industry thought leaders may support this view: “More lending into the productive part of the economy is a necessary part of the re-engineering of New Zealand” – Cameron Bagrie, New Zealand banking sector economist. “Dairy is a key to New Zealand’s future. No one has yet found an alternative to dairy for New Zealand’s export led economy” – Keith Woodford, agriculture college professor. Conclusions The Reserve Bank of New Zealand’s capital adequacy requirements have placed higher regulatory capital demands on banks, reducing the profitability of lending to rural industries. This has led to a decrease in lending to the dairy sector from 2018 onwards, negatively affecting capital availability, land valuations and sector growth opportunities. OIO changes in 2018 compounded these challenges by restricting overseas investment in NZ farmland, further reducing capital inflows and affecting market dynamics. The impact of the RBNZ regulations is significantly more substantial (ca. NZ$2bn annually compared to NZ$200m from the overseas capital restrictions). In spite of these challenges, export earnings from the NZ dairy sector continue to increase. Export revenue and EBITDA per hectare have increased significantly. However, this revenue growth has not yet led to a corresponding increase in land values, in part also due to the recent rise in interest rates, which flattened a brief market price uplift in 2021. The recent inflation surge is aiding the Reserve Bank of New Zealand (RBNZ) in deleveraging the dairy sector. A normalisation of interest rates to slightly lower levels over the next 12 to 24 months has the potential to kick-start the land capitalisation process. Public debate is now beginning to recognise that the policies may have largely achieved their objectives. The time has come to review them and to address their unintended consequences for future industry investment. In particular, the new coalition government tell us they are aware of the need for change. Therefore, policy settings may be expected to normalise over time. Improvements in sector liquidity are essential and should enable the industry to invest and contribute to GDP; assist with farm succession; and contribute to de-carbonisation. If you have any questions about the report, or any other farming matter, please contact us at the email addresses below. Forbes Elworthy, Founder forbes.elworthy@craigmore.com Che Charteris, CEO che.charteris@craigmore.com Nick Tapp, Chairman CS LLP nick.tapp@craigmore.com 1. Mazzetto, Falconer and Ledgard, 2021 2. CarbonBrief 3. DairyNZ 4. Land capitalization typically lags behind profit margin expansion by 2-3 years. In 2021, as margins began to expand, the market saw an initial rise in land values. However, this increase was short-lived due to the subsequent rise in interest rates. Although operational returns have significantly improved, land values remain closely tied to the official cash rate. The greater cost of finance in recent years has offset the gains from improved operational margins for now. 5. Ministry for Primary Industries Published: 4 July 2024
