OREANDA-NEWS. A second year of low milk prices will raise asset-quality pressure at New Zealand banks, says Fitch Ratings. The full impact will depend on how long it will take milk prices to recover, and on future interest rates and the level of the New Zealand dollar.

New Zealand's banks have significant exposure to the dairy industry. Dairy farmers account for the bulk of agricultural output, and dairy loans make up nearly two-thirds of total agricultural loans while agriculture accounted for 14.5% of total banking system claims in April 2015, according to the Reserve Bank of New Zealand (RBNZ).

Exposure at financial year-end 2014 at the country's four largest lenders was: 15% of total credit exposure at Bank of New Zealand; 12% at ANZ Bank New Zealand; 11% at ASB Bank; and 8% at Westpac New Zealand.

Farmers are well placed to withstand this season's weaker prices because of the substantial cash payout by Fonterra Co-operative Group Limited (which exports 95% of the milk produced by New Zealand farmers) from the 2013-2014 season, which was the highest to date. Smaller payouts in this season were widely anticipated following last year's drop in global dairy prices, and farmers have generally used last season's high prices and dividends to pay down debt or invest. Deleveraging should make the sector more robust, although supply could rise and prices fall further if farmers invest in fixed assets.

The depreciation of the New Zealand dollar since mid-2014 has cushioned farmers from the impact of global price falls by supporting prices in New Zealand dollars.

Nevertheless, the failure of prices to recover towards the long-term average of NZD6.00 per kg of milk sold by mid-2015 will exert pressure on asset quality within banks' dairy exposures. Last month's RBNZ Financial Stability Report projected that lower payouts could result in 25% of dairy farmers experiencing negative cash flow.

Banks' credit assessments when lending to dairy farmers tend to incorporate long-term average payouts. If payouts remain below levels used for serviceability assessments, these may prove too generous for the most highly leveraged borrowers (RBNZ analysis has shown that 10% of dairy farms account for around one-third of sector debt).

Dairy farmers are more vulnerable to rising interest rates than in the past. RBNZ data shows that floating-rate loans amounted to 72% of total dairy lending in June 2014, up from 16% in 2008. Lower milk prices could have an indirect effect on dairy loan asset quality, if lower farm incomes weigh on economic growth and sentiment sufficiently to influence monetary policy and reduce pressure for further tightening. However, this is far from certain.

Lower milk prices also widen New Zealand's current account deficit, increasing the economy's reliance on external funding. This could make domestic funding conditions more sensitive to changes in global liquidity and investor sentiment.

We anticipated a modest deterioration in asset quality across banks' loan books in 2015 following the cumulative 1pp increase in the official cash rate (OCR) last year. System impaired-loan ratios have started rising from cyclical lows in the six months to end-1Q15. New Zealand banks are generally well capitalised, have strong profitability and sound asset quality. This gives them ample capacity to absorb impaired-loan levels similar to 2009-2010.

Fonterra cut its forecast Farmgate Milk Price for 2014-2015 by 10c per kg of milk sold to NZD4.40 last week, the lowest in eight years. It set its opening forecast for 2015-2016 at NZD5.25 per kg of milk sold. Combined with its forecast dividend range, cash payouts to its members for 2014-2015 will remain below the long-term historical average.