Accidental rock stars are creaming it

MARKET VALUE: Dr Keith Woodford
MARKET VALUE: Dr Keith Woodford

It happened in 2013. In a single year, New Zealand's exports to China leapt a mind-boggling 45 per cent, increasing by a whole $3.1 billion to $10b, making China now our biggest international customer.

Australia got knocked off the top spot it had held since 1989. And while the change might have been predicted, its speed and scale has still left New Zealand producers stunned.

Dairy led the charge. Milk powder was 40 per cent of what we sent across the waters and with sales accelerating all through last year, no wonder farmers are now looking at an all-time record high payout of $8.30 per kg of milk solids.

This is despite an alarming series of industry blunders, including the dicyandiamide contamination farrago, Fonterra being fined as part of an infant formula price-fixing probe, and easily the worst mistake, the botulism scare which has now seen one of Fonterra's key customers, French food giant Danone, tear up its supply contract and launch a damages suit for around $500 million.

Even with all that bad news, the year ended with the month of December itself breaking all records, seeing exports to China increase by a whopping 67 per cent over December 2012.

But it is not just milk that was earning. In the end of year agricultural trade wash-up recently released by Statistics New Zealand, absolutely every trend line is pointing straight at the sky.

Logs, lamb, beef. The combination of three factors - the signing of a free trade agreement (FTA) back in 2008, the emergence of a rich middle class in China, and a lag in the modernisation of China's own food production system - means that the demand for what New Zealand can produce has suddenly turned insatiable.

Lincoln University agribusiness professor Dr Keith Woodford, who has been visiting China for 40 years, says the stars have aligned for the New Zealand economy in a way that has not been seen since the 1951 Korean War wool boom when prices tripled overnight after a panicky United States decided to start stockpiling winter uniforms.

And Woodford points out the wool boom lasted only a couple of years whereas the China boom looks set to last a decade - if indeed it is not a permanent shift in the balance of demand.

"People have been hearing our future's in Asia, our future's in Asia, blah, blah, blah. But all of a sudden it is hitting us. We've just seen a tenfold increase in our exports of beef to China last year. Now that has come off a very low base, but it's still a shock to most people."

Easy times, says Woodford. "There's not a lot we are having to do at the moment except sit on the end of the phone - that's all the meat companies are doing basically. They're sitting at the end of the phone and the Chinese buyers keep ringing up crying ‘More product, more product!'."

It seems Australia's loss is our gain. Woodford says the Aussie economy enjoyed this kind of free ride while China was in its infrastructure development phase and was hungry for coal and iron ore.

Now it is our turn. The iron man is being replaced by the milkman as Australian commentators are sourly noting. New Zealand is set to benefit as China moves into a more mature consumer-led stage of growth.

Woodford says for the foreseeable future, yoghurt, steak and other supermarket delicacies will be the business to be in. At long last, global trade looks to be playing to New Zealand's traditional strength.

"Yes, we're in a remarkable sweet spot at the moment. And the thing is that it looks like a genuine long-term demand change, not just a passing commodity price spike."

This is why there is all the talk about New Zealand's rock-star economy - why when the Reserve Bank Governor, Graeme Wheeler, addressed the Canterbury Employers' Chamber of Commerce a few weeks back, his main concern was about managing a period of rapid expansion.

Wheeler could boast that New Zealand's 2.7 per cent growth rate is now double the average of other developed nations. "Most of our economic indicators are positive with the terms of trade at a 40-year high, business confidence is the strongest since 1993, and consumer confidence is at a seven-year peak."

The difficulties, says Wheeler, are thus a high dollar and the threat of inflation. The consequences of too much success. Interests rates are likely to have to go up, which will hit Kiwis with loans and mortgages. And an overvalued currency is going to be hard on any export business not involved in the food trade with China.

But then again, that high New Zealand dollar is making smartphones and other imported consumer goods appear much cheaper than they really are. Or more importantly as a nation, we look like being shielded from the true world cost of oil for a good while longer. And likewise, jetting across the Ditch to flash the cash under Aussie noses is going to remain a more affordable treat.

So there is a lottery win feel about things. Say it again - a 45 per cent increase in sales to a single customer in a single year. The realisation is only just starting to sink in.

Yet then of course rises the thought of whether life can truly be so rosy? New Zealand does have a golden opportunity here. But as usual there are also a lot of ways we could stuff it up.

The change starts with the 2008 free trade agreement - although that is not so significant in itself.

Under the China FTA, the tariff reductions have been kicking in steadily, another slice each year. While they will not reach zero until 2019, already they allow New Zealand goods to undercut the international competition.

However Lincoln's Woodford says this market edge is only temporary. Others like Australia will eventually get their trade deals too.

And also, as it turns out, dairy sales have been so high that they far exceed the tonnage where the FTA's discounts even apply.

Woodford says given China's state planned approach to its economy, the impact of the FTA is more about the way it gives New Zealand the official seal of approval. "The advantage was psychological. When the agreement was signed, that was a big signal to Chinese companies we were a country you could be confident of doing business with."

Woodford says the real market story is instead about the interaction between China's rapidly emerging middle class and its lagging food production. This is the complex equation New Zealand has to understand.

China does have a plan behind its staged economic development. First came the flat-out manufacturing export drive - double digit growth for a couple of decades based on its advantage of centralised planning and peanut labour wages. It has achieved that, says Woodford. So now it becomes about establishing a strong internal consumer economy while undertaking a second modernisation drive in its countryside.

It has certainly got the new consumers.

Dominic Barton, global chief of market researcher McKinsey, reports that as recently as 2000, only 4 per cent of the urban households in China could count as middle class - having disposable income. Now it is nearly 70 per cent, making a completely new world market of 300 million people. And within another eight years, that will hit 630 million.

Barton says China is already buying nearly as many digital cameras as the United States, and rather more flat-screen TVs and laptops. Even a humble product like laundry softener has increased in sales by 20 per cent every year for the last five years.

Victoria University political scientist Dr Jason Young, another regular visitor to China, says it is the scale which is so hard to appreciate. As a recent KPMG agribusiness study notes, just in terms of internal migration, the predictions are that the number of Chinese moving from the countryside to better paid jobs in the cities is going to run at more than the entire population of New Zealand for every month for the next 35 years.

"China is only 50 per cent urbanised at the moment. So you have this constant creation of new consumers who are suddenly going to the supermarkets, suddenly starting to think about what's best for their children growing up, like dairy products and protein. So even if China's economy slows, that structural change of more urban consumers will still be going, still increasing the demand."

Young says the other side of this coin is then that China's whole food production system is still stuck much where it was left in the 1980s.

After Communism, Chinese farming reverted to small family plots - sustenance agriculture with little scale. A dairy farm might be a dozen cows in a barn in a village. And Young says there are not the national supermarket chains, food manufacturing companies, food safety regimes and other industry infrastructure to tie it altogether.

There is no question the Chinese will get organised. It is already happening, he says. Young has recently returned from a trip to see the giant barn farms, housing 2000 to 3000 cows, that Fonterra has been helping set up and operate in Hebei province.

It is a smart move by Fonterra, Young says. New Zealand will have a foot in the door when it comes to genetics and technology as China starts to redevelop its countryside. But the long-term intention is clear.

As its population moves out of the villages and into the cities, the rural areas will be caught up. China will consolidate land and build a modern agricultural system to feed its own middle class with home-grown yoghurt and steak, if that is their taste. And probably the year after catching up with its internal demand, China will turn around and start being a food exporter, given its industrious record.

"They need to do a lot of work with their farm systems, their distribution networks, their food technology. All of that is a major priority. But if we look back at China's history since the 1980s, we know they will do it," Young says.

Woodford is still sanguine. He says China's leaders know food security is essential if they want to stay in power. A hungry population is a dangerous population, so China will import where it makes sense.

To produce all its own milk in barns, it will need to grow cow feed. Which given land and water shortages means even now importing corn and alfalfa from the US. So why not just build strong ties to an efficient low-cost producer like New Zealand?

Likewise lamb. Woodford says China could scale up to meet its own requirements, but - surprising as though it may sound - it is serious about its own environment too. China's national sheep flock has shrunk from 150 million to 130 million as national conservation measures have been kicking in.

"The sheep were traditionally farmed on arid grasslands and over considerable areas the sheep have been totally removed," says Woodford. "I've got a little project up on the Qinghai-Tibet plateau and there's a conservation zone there - it's larger than the size of New Zealand."

Woodford says more of an issue is that if China continues to be the profitable market of the past few years, other countries will gear up to export there as well.

The Irish and the Danes have been mobilising. And for a long time New Zealand farmers have been worried about South American countries like Chile and Argentina coming in with the same pasture-based systems, but on the back of lower land and labour costs.

However Woodford says the US would trouble him most. California has developed enormous feedlot farms where fodder is trucked in and the milk production per cow is far above New Zealand's.

If the US decided to get rid of its trade barriers and go after China exports as well as its own domestic market, that would be stiff competition.

So China has a politically sensitive gap between demand and supply that could take at least a decade to fix internally. And New Zealand - as one of the few nations, along with Brazil, that is organised to produce a national dairy and meat surplus - has a headstart to service that need.

With a population of 4.4 million, New Zealand grows enough to feed 40 million people. Or more sensibly, meet 5 per cent of the diet of 500 million middle class customers. This equation explains why the Government is now focusing national economic policy so strongly on agriculture.

There seem to be two main ways it could all go wrong. Well, three if you include the possibility of China blowing a gasket, its growth tanking because of the toxic debts and property speculation building up within its shadow banking system as many pundits fear - although the same pundits add if that happens, the global economy is stuffed anyway.

Those risks are first complacency, and second that Fonterra makes a muck of it.

In economics, complacency is known as the Dutch disease. In the 1960s, the Netherlands made a natural gas find and the easy revenues led it to neglect its traditional manufacturing sector. The same story of a resource-based bonanza making a country soft has been repeated many times - Australia being seen as one of the latest example.

"Success is way more dangerous than failure," agrees Chris Claridge of infant formula startup, Carrickmore Nutrition. "With failure, at least you know you've failed, but success can make you blind to the realities of what is occurring."

Claridge, who gave up his Christchurch digital media business in 2012 to join the goldrush into the Chinese baby milk market, says we are likely to hear all sorts of bold talk about how New Zealand is going to use the China opportunity to leap into value added products - break out of the low-return commodity milk powder industry and take on the big boys like Danone and Nestle as a food multi-national.

As any marketeer knows, says Claridge, the real profits in the food industry lie in the delivery of the finished products and supermarket brands.

A report last month from Auckland's Coriolis Research on infant formula shows the break-down on a $48 can leaves $2.70 to the farmer and $1.70 to the dairy processor, while $26 goes to the company with its name on the label and $13 to the shop selling the can.

Claridge admits this is extreme as infant formula edges into the territory of pharmaceutical sales and their lopsided pricing models. Also farmers make half their profits in land ownership these days - they are earning tax-free capital appreciation on the property they own.

However New Zealand certainly ought to be using its current flood of earnings to invest back into actually climbing the value chain and his fear instead is the country will simply relax because the money is now rolling in.

Woodford agrees, saying he is seeing exactly this happening with lamb producers.

Woodford says for a number of years, firms like Silver Fern Farms have been struggling with special cuts, special packaging and special branding to establish some kind of named presence in foreign markets.

But last year, partly because of an explosion in hot pot fast food restaurants

in China's big cities, the Chinese started paying unheard of prices for even the fattiest offcuts - the caps, flaps and other unwanted bits that used to go to the Pacific Islands or even pet food.

"One industry leader described it to me as going back to the future. The China boom means we've been shifting from the processed stuff back to just basics.

"We're chopping the sheep into six frozen carcass bits, shoving them in a box, and sending them off. There's actually less boning out going on in the sheep industry now than for many years," says Woodford.

So a lot of opportunity might slip New Zealand by because while everyone will be making the right noises about innovation and development, the reality could be that the food industry falls back into the most simple-minded forms of production as the least line of resistance.

Then there is the question mark over Fonterra and its competence. Again, China has looked an opportunity for Fonterra in particular to step up as the national champion, start mixing it with the multinationals who are also the main customers for its milk powder.

And this seemed to be happening, not just with Fonterra's overseas farm investments but with its launching of an own-brand infant formula in China and its building of a $126m UHT milk plant in Waitoa, a $61m cream cheese factory in Te Rapa. Fonterra looks to want to create an across-the-board dairy product line that can leverage off New Zealand's "clean and green" image in the Asian market.

But Carrickmore's Claridge laughs at such ambitions. He says Fonterra might be large by our standards, but as soon as it sticks its head above the parapet, the Danones and Nestles of this world will knock it off.

And so will the Chinese. Claridge says the Chinese government is making it plain it wants to create its own international-scale food manufacturers and supermarket brands. There just is not the room for a bantamweight like Fonterra.

Claridge says much more of a concern to him is that Fonterra simply does its job right.

The one fact about the food industry is that it is exceptionally vulnerable to food safety scares. And a dirty pipe in a Fonterra milk powder plant was enough to spark last year's botulism false alarm.

Claridge says New Zealand has taken a huge risk in adopting a hands-off approach, allowing a farmers co-operative to control the country's largest business.

"As a country, we've given our biggest national resource to a group of farmers to operate as a monopoly without any real oversight from the economy within which they are operating."

Claridge says the Chinese are frankly baffled. They see Fonterra as an arm of government and treat it as such. So when the problems erupted last year, the New Zealand Government's grip on the situation looked flimsy.

China's current demand is such that trade has carried on, says Claridge. But another mishap and China might say enough is enough. It could simply dump Fonterra as a supplier and pay what it takes for Ireland, Denmark or whoever else to fill the gap.

Federated Farmers' dairy chair Willy Leferink comes to Fonterra's defence. When you are riding a time of extraordinary market growth, hiccups will happen. The scares were just scares and the Chinese were impressed by how quickly New Zealand owned up to potential problems.

And Leferink, who farms near Ashburton, says Fonterra understands its own long-term goals. It will dabble in profitable brand lines but its chief global niche is in going to be in food ingredients. And that is a lucrative proposition.

"Fonterra produces a lot of milk powders with a number behind them that are specific to a customer's requirements - like extra protein so they don't have to put eggs in and all that sort of stuff. So it is not a commodity industry anymore but an ingredient industry."

Leferink says farmers also know that China may be this year's story, but the reason for Zealand to be excited is that the whole of South East Asia is coming on.

He recently visited Vietnam and was impressed by the economic fundamentals - the level of education and investment. The same is true of Thailand, Malaysia and Indonesia. They have big populations, fast emerging middle classes, and will be around for a long time.

Tim Morris at Coriolis Research, who has authored reports for New Zealand Trade and Enterprise and other Government agencies, agrees, saying 2013 was a big year when it came to China and 2014 will be another, yet level-headedness is needed.

Morris says economic cycles last seven to 10 years. And while the 2008 global financial crisis might seem only yesterday, we are now six years into the current rebound, so the next world downturn could be just around the corner. He is one of those pundits who can imagine a wrenching correction caused by China's over-expansion.

So the strategic thinkers are looking far past China, he says. "Everyone in the industry who has their heads screwed on straight realises we are already over-exposed there and will have been taking steps to deal with that."

However long term, the world has a growing middle class population and New Zealand has its unique advantages as a food producer.

Morris says New Zealand once sent 95 per cent of its exports to Britain. The game now is diversification. This is why the Trans-Pacific Partnership (TPP) trade agreement matters. If the negotiations get across the line, it will open up new Japanese and US markets to New Zealand. Then over the coming century, it will be tropical Asia that is our real opportunity, Morris says.

China has its temperate north that can produce the same kinds of foods that New Zealand does - milk, beef and lamb. But in future years it is the same countries that excite Leferink - Vietnam, Singapore, Indonesia, the Middle East as well - which will be our most natural markets.

"Saudi Arabia, while they've got the oil, might be able to have dairy cows in air conditioned barns. But realistically, tropical countries can't produce the kinds of food we can produce, efficiently and effectively. Long-run, they will be our best customers," Morris says.

So 2013 represents a shift. It probably confirms New Zealand in its strategy of focusing on food production. It may even mean an easier time for quite some time to come. However, as is being said, there is not much room to relax. Opportunity is when the real work ought to begin.

The Press