The commodity supercycle has been kind to New Zealand, a small open economy that has seen huge growth in demand for its main export products coming from the rapid development in China. Much of the strength in the New Zealand Dollar (NZD) over the past decade has been related to the rise in export prices, which have boosted incomes and allowed the domestic economy to grow rapidly without the resulting rise in consumer goods imports causing much of a decline in the current account.
However, recent developments in dairy and forestry prices highlight the risks of relying on a single export market, especially one as difficult to predict as China. Prices for Whole Milk Powder have fallen by 46% since February, while log prices are down 44% from the levels in March this year. These are important developments for New Zealand with dairy products representing almost a third of exports and forestry products a further 12%. How permanent are these price falls and does this mark a turning point for the NZD?
Whole milk prices fall another 11.5% in the bi-weekly Fonterra auction and are now down ~50% since Q3 last year
The causes of the declines in dairy and log prices are somewhat different, but both relate to Chinese policy decisions. Specific policies introduced following food safety scandals to improve the quality of locally produced dairy products have reduced demand for imported dairy from New Zealand. Logs are primarily used in Chinese housing construction and have been affected by government efforts to slow house price appreciation, while construction is no longer increasing as the reconstruction of poor quality housing stock is now completed and demographic shifts will see new household formation stabilizing despite ongoing urbanization.
Without the support of rising export prices, the NZD appears significantly overvalued on our long term metrics, suggesting the potential for a large fall when demand for carry trades slows. As the strength of the domestic economy also looks to be fading and volatility is rising across other asset classes, it is time to look at ways to combat a weaker NZD.