OREANDA-NEWS. A substantial cut in the forecast per-kilogram milk payout for New Zealand dairy farmers in 2015-2016 will act as a headwind to economic growth, and is likely to have an impact on banks' profitability and asset quality, says Fitch Ratings. That said, both the economy and banking sector are relatively well positioned to weather a cyclical downturn in the dairy market, and we do not expect low milk prices to hurt the ratings of the sovereign or major banks. However, the risks of a more substantive effect on the economy and bank balance sheets is likely should the dairy market fail to recover in 2016. 

Dairy cooperative Fonterra announced on 7 August that it had cut its Farmgate Milk Price forecast for the upcoming agricultural season to NZD3.85 per kilogram of milk solids (kgMS) from NZD5.25 - the lowest price since the 2005-2006 season. The forecast total payout for farmers for the 2015-2016 season will be between NZD4.25-4.35 when factoring in forecast earnings per share of NZD0.40-0.50. Furthermore, Fonterra announced that it is offering additional support for farmers in the form of a loan of NZD0.50 per kgMS produced, backed by shares in the cooperative. The loan will be interest-free for the first two years, and repayable when the Farmgate Milk Price or Advance Rate rises above NZD6 per kgMS for those farmers that utilise the facility. 

Dairy products comprise approximately one-third of New Zealand goods exports, however Fitch expects only a limited immediate effect on the economy from the fall in prices. Notably, the short-term supply response should not be substantial, owing to high fixed costs which should keep output and export volumes relatively unaffected in the next agricultural year. 

There are risks to domestic demand and to government revenues from the expected decline in incomes. But there are few signs as yet that these effects will have a substantial drag on economic growth. Consumption growth remains robust, and households have some room to maintain consumption patterns through dis-saving in the short term. Strong construction and labour supply growth have also continued to support the economy. 

Furthermore, there is potentially significant space for domestic demand to be supported by eased monetary conditions. The Reserve Bank of New Zealand's official cash rate is 3%, and the bank signaled that further loosening would be likely after a 25bp cut in July. The New Zealand dollar, which has depreciated by over 15% year-to-date, should also act as a support to domestic demand and terms of trade. 

Banks are also in a relatively healthy position, and should be able to manage a cyclical decline in milk prices without a ratings impact. New Zealand banks have underwritten better-quality business compared with the last milk-price downturn in 2008-2009; and their exposures are well collateralised by land, Fonterra shares and livestock. The exposures above 65%-70% loan-to-value ratios also appear to be small and manageable. In addition, capitalisation has improved significantly since the last downturn - supported by strong and consistent profitability. 

New Zealand credit remains well-positioned for now, and consensus expectations are for milk prices to rise again later this season. However, it would be much more likely that production would be affected if milk prices stay at current levels through 2016-2017. This in turn would act as a more substantial drag on GDP growth while compounding the negative effects on incomes and domestic demand. For New Zealand banks, the effects on profitability and asset quality would be potentially much more significant, and their ability to continue supporting farmers without having their own stability affected would come into question.