New Zealand's big bet on China

Wednesday, May 7th 2014, 9:30AM

by Andrew Hunt

To many particularly Northern Hemisphere analysts, New Zealand’s recent impressive rate of economic expansion has been led by a mixture of necessary earthquake reconstruction and what some tend to think of as being yet “another” housing market boom. Certainly, the unfortunately all-too-necessary Canterbury reconstruction effort is now approaching what will likely prove to be its peak rate and in so doing it is adding a significant amount to Gross Domestic Product, although as to whether it is adding much to Net National Product is less certain.

Replacing a damaged capital stock will lift GDP but not necessarily a country’s “wealth” (although in this regard NZ is perhaps fortunate that many of its insurers were based “overseas”).

Similarly, there is no doubt that several parts of the NZ property market have been very strong until recently (particularly Auckland and Christchurch) but even if we include the Canterbury rebuild, gross investment in the residential housing stock can only account for around a quarter of the 4% rise in total GDP that has occurred since June 2012.

Clearly, there has been a lot more to NZ’s recent growth spurt than simply construction activity and in our experience many residents have tended to view the rise in house prices that has occurred over recent years as representing an increase in their effective cost of living rather than an excuse to spend more in the shops. We have long been sceptical that “wealth effects” from house price gains matter as much in the 2010s as they did in the boom years of the 1990s.

Interestingly, we should perhaps note at this juncture that there are also two things that seem to have contributed relatively little to NZ’s recent growth. Firstly, and despite its recent modest revival, household sector credit growth has been relatively muted and certainly not as extreme as it had been on previous occasions. There have been signs of localised credit-fuelled excesses (which the RBNZ may have already curtailed via its higher loan-value regulations) but in general credit growth has been quite moderate with regard to the household sector. Secondly, and in a development that has surprised virtually everyone, average wage and household income growth has tended to be very modest over recent years. Indeed, even the RBNZ has been surprised just how low wage inflation rates have remained and this is undoubtedly a major factor behind their seeming reluctance to raise interest rates aggressively.

Overall, it seems that while the earthquake reconstruction, higher levels of housing market activity and some modest increases in both average wages and credit have helped NZ’s economy to expand, even together these factors are not the whole story behind NZ’s recent better growth numbers.

Instead, and this is less well appreciated – particularly outside the country, the massive improvement in the country’s terms of trade since early 2012 has had a major impact on the economy. Indeed, it is thought that the improvement within the terms of trade has added some 9% to national incomes.

There have been two primary causes of the improvement within the terms of trade; firstly, import prices have been remarkably subdued as a result of the continuing global economic malaise but New Zealand’s export prices have been extremely buoyant, largely it seems as a result of a surge in exports of milk products to China.

Since 2010, New Zealand’s exports of dairy products have risen from around NZD10 billion a year to over USD13 billion, despite the strong NZD, and the majority of these increased shipments have apparently been bound for China. In fact, it seems that China has become a major source of export and tourism receipts for the economy and given this development it is not too surprising to find that the NZ Government is now courting China; apparently every Cabinet Minister is expected to visit China at least once this year.

Returning to the subject of the “white gold” and NZ’s milk exports, we find that two-thirds of the increase in milk export revenues can be attributed to the rise in milk product prices and that milk export volumes have only increased by a couple of percentage points each year. Given the relatively price-inelastic supply that characterises most types of agricultural products, the lack of volume increase is perhaps not terribly surprising – it can be argued that milk yields are in many ways simply a function of land area devoted to cattle-rearing and the amount of rainfall that has been received by that land, although many farmers have, it seems, been attempting to lift yields through heavy investment.

In fact, we find that investment in the agricultural sector has risen by around a fifth since 2012 and the effect of this increase in current CAPEX, coupled with the rise in land prices that has occurred largely as a result of the dairy boom (as the RBNZ itself notes, the rise in milk prices has been well and truly capitalised into land prices), has been to make NZ agriculture significantly more capital-intensive than it was. NZ farmers now own more dairy cattle, more fences and more dairy-related agricultural machinery and plant than ever before but these assets are in many cases mirrored on the liabilities side of the farm sector’s balance sheet by high levels of debt.

This quite understandable development does however represent a possible risk to NZ’s recent seemingly strong economic performance. During 2007-2008, when the US mortgage crisis unfolded, large parts of the London and New York capital stocks were made worthless almost overnight. Over the preceding four or five years, it seems that vast sums had been invested in creating a trading, management, origination and valuation infrastructure for mortgage products such as the now infamous CDOs but, when the mortgage crisis unfolded and interest in these products all but evaporated, this capital stock was instantly redundant. In effect, the assets that had been acquired during the boom were notionally “wiped out” but unfortunately any debts that had been incurred during the “CAPEX” boom were still in existence and this added to the banks’ and other financial institutions’ problems at that time.

Unfortunately, if the milk price were to fall precipitously (and it has already been weak), we wonder whether the same thing could conceivably happen to NZ’s agricultural sector.

As history has shown rather too many times over the last few centuries, sharp falls in agricultural (export) prices can wreak havoc in economies that are highly dependent on agricultural output and prices for their wealth – and particularly in those economies that show a tendency to “capitalise” high agricultural prices in bricks and mortar.

One only needs to drive down the East Coast of the South Island to see the peaks of previous commodity prices etched on the facades of some of the grander buildings in Timaru, Oamaru and even Dunedin.

At present, it is almost impossible to know just what is occurring within China’s domestic economy: the economic data is not always that reliable and it has certainly become a great deal less timely over recent months. For our part, we suspect that China has recently come to the end of a simply massive credit boom that had been “inflating” many parts of the domestic economy – including local wages and incomes.

Now that China’s credit boom has come to what seems to have been quite an abrupt end, though, we not only suspect that the country’s underlying rate of real economic growth will slow very significantly but also that some of the “price inflation” that was experienced during the boom years will be reversed. Certainly, we suspect that China’s wage rates will decline in USD terms over the next few years (in fact, this process has already started with the weaker RMB exchange rate).

The question for NZ at this point has clearly become just how much of the inflation of milk prices that has occurred over recent years and which has led to so much investment in the dairy sector was simply a mirror of an unsustainable inflation of Chinese wages during the boom years? If it transpires that China’s economic problems do lead to further falls in milk prices, then dairy farm yields could well fall with a predictable result on not only new investment trends in this vital sector of the economy but also the sector’s net wealth. If milk prices were to fall below the marginal cost of producing milk, NZ’s farmers would be left with high fixed costs and operating losses.

Clearly, NZ has a lot riding on China’s economic fortunes at present. In a perfect world, the government might have been able to “lay off” some of this implied gamble by taxing any “exceptional” prices of the farm sector in much the same way as Norway and others do with regard to their commodity producers (so that they could fund a “rainy day” fund) but politically this was probably an impossible project and hence it seems that the medium-term outlook for NZ will not depend on what happens to house prices or even, we suspect, the rebuild.

Instead, the medium-term outlook for growth within NZ will likely rest on what impact China’s economic slowdown has on the price of milk globally and the NZD. It is quite possible that if the milk price falls then so will the NZD, with the result that the domestic farm sector is insulated but if foreign investors continue to focus on the relatively high yields on offer in NZ debt instruments and on trends within the housing market, then it is by no means certain that the NZD would fall – at least without some help from the RBNZ....

Andrew Hunt is a London-based economist

Andrew Hunt International Economist London

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