The milk powder bans

The NZ milk powder bans dairy product bans  (make that all dairy products for Russia, and milk powder from Australiasia from China), in China and Russia are undeniably a big deal.  The most important point is of course that no-one gets hurt – so having the countries ban milk powder until there is information available makes sense. The encouraging sign in this regard is:

Capital & Coast District Health Board infectious diseases specialist Dr Tim Blackmore said botulism was extremely rare in New Zealand.

Given the time since the contamination and that no cases had been reported, it was unlikely the bacteria would still pose a risk, he said.

So that is a plus.

Given all this, people will also be interested in the ways this type of event may impact upon economic outcomes in NZ.

A point people will bring up is the impact on Fonterra’s reputation – and the impact it receives on any “premium” received for dairy products.  I will just leave that to the side here.

Instead I’m going to focus on how this is different than other “shocks” to demand for a small open economy, in the short-term.

Usually, I’d point out that NZ only makes up about 1% of global dairy supply.  As a result, if a bunch of countries banned our products we would just sell (as a residual claimant) somewhere else – Fonterra might have to put up with slightly lower prices, but quantities wouldn’t change.  And so near term GDP wouldn’t suffer a direct hit from agriculture.  Consumption etc would be lower, as our incomes would be, but GDP wouldn’t necessarily be hit.

So if this had happened randomly, the fact that China (24.7% of our dairy exports in the June 2013 year) and Russia (1.2%) banned NZ exports may not have all that big an impact.  However, this isn’t a random shock – it actually stems from a characteristic of NZ production!

The magical ability of a small open economy to do this relies on the idea that they are selling a homogenous good.  But this is a specific NZ shock – people all around the world are a bit nervous about Fonterra – hence an article about it on Bloomberg.  So the entire demand curve for NZ dairy products has fallen – implying that the price effect will be larger.

On top of this, a bunch of the “stock” of dairy production has been destroyed.  It is now essentially worthless and this is a cost.  Since it sounds like none of this milk powder has been sold in its retail form we need to ask whether it had already been exported by not reached retail yet (in which case Fonterra’s compensation to these groups will turn up in the capital account) or whether Fonterra still had it on hand (in which case it was in inventories – and will appear as a drop in inventory accumulation in the GDP stats).

How extreme this is for the near term outlook for Fonterra, and the broader NZ economy, will come through in the exchange rate and Fonterra’s share price today.  The Global dairy trade index could also be useful heads up – but remember that it includes a whole bunch of suppliers, not just Fonterra!

Note:  And before people go to make some sort of firms/insufficient regulation are evil/the cause – lets try to understand how these things happen.  Ex-ante all firms, institutions and individuals are taking on risk (this includes government) – the fact something happens ex-post doesn’t mean it was “100% likely” ex-ante, and given ex-ante expectations (probabilities of things happening) people were making choices.  There may well be some type of institutional failure, or it may be down to some sort of “production line” failure the occurred even in the face of best practice.

This is not to say this was due to genuine uncertainty – this sounds like the sort of thing that a probability distribution can be pinned to.

And for people suggesting regulation, I’m genuinely unsure what type of regulation helps here.  It sounds like a knee-jerk “something must be done because” response, rather than anything that makes sense.  Let us at least try to answer some questions first, how did the pipe get contaminated, what are the probabilities around it getting contaminated in that way?

Update: On the reputation impact Liam Dann has a good piece here.  I’d just be a little bit careful with the final line though:

This is a warning to us all that New Zealand needs to keep pushing to diversify its economic interests beyond the farm gate.

Fonterra is a firm, not New Zealand.  Being a small open economy with a large exporter it does involve risk and the benefits of specialisation, this is true.  But the question is more why New Zealander’s aren’t diversifying and their incentives – not a question of how we could make them diversify.  This distinction is subtle, but important.

ANZ also comments on reputation impacts here.

Update 2:  Good post by Homepaddock on this.

Update 3:  Aaron Schiff comments on the idea of diversification – pointing out that Fonterra was created legislatively, not by way of a competitive market.  Good point.

Update 4:  Interesting facts from a bunch of experts in microbiology and medical sciences.  Via Peter Griffin.

Update 5:  China’s ban is only on whey and infant formula – not broad milk powder.  Also sounds like much of the product had been sold on – implying this will turn up more in the capital account than GDP (in a direct sense).