This is how the global dairy glut is flowing through to major Australian banks

A worker at a milk production line in Hangzhou, China. Feng Li/Getty Images The impact of falling prices due to a global glut of dairy products is starting to flow through from New Zealand farms to major banks in Australia.

The NAB and the ANZ bank are the most exposed, holding between them about a quarter of all agriculture loans in New Zealand and the majority of those to dairy farms.

This week Fonterra, the world’s second largest milk processor, forecast that its milk payout for the season ending in May will be $NZ3.90 per kilogram of milk solids, down from its previous forecast of $NZ4.15 and well below the $NZ5.25 at the start of the season.

The ratings agency Moody's says the decline is credit negative because a lower payout reduces the income of farmers and threatens the asset quality of banks exposed to the dairy sector.

Slower economic growth in China, a major export market for New Zealand’s milk producers, has weakened demand. And in Europe, production is strong but Russian import restrictions have closed a major market to those producers.

ANZ Bank New Zealand Limited, ASB Bank Limited and Bank of New Zealand (whose parent is the NAB) are the most exposed to New Zealand’s agricultural sector among New Zealand’s five largest banks. The other two banks are Westpac New Zealand Limited and Kiwibank Limited.

Dairy loans make up an average of 70% of the five banks’ total agricultural loans.

Moody's says a weakened dairy sector has a meaningful second-order negative effect on New Zealand’s economy.

There's a strong correlation between the price of milk and non-performing agricultural loans, as this chart shows:

Despite the sharp drop in the milk price, the agricultural non-performing loan ratio has been flat.

This is mainly because farmers knew well in advance that prices would be lower than the previous year, allowing them to manage expenses and defer significant capital expenditures.

"That said, we expect the asset quality of those banks with dairy exposures to come under pressure as farmers face a second consecutive season of low dairy prices and are likely to have less capacity to reduce expenses further," says Daniel Yu, a Moody's senior analyst.

"Indeed there are signs of emerging stress."

In its first quarter 2016 trading update, NAB, the Australian parent of Bank of New Zealand, announced its non-performing loan ration rose to 0.68% at December from 0.63% at September 2015 owing to the inclusion of a number of dairy exposures.

The New Zealand economy is also feeling pressure. Its terms of trade fell 2% in the December quarter, weighed down by dairy exports whose value fell 13%.

Some dairy companies are managing to do well, mainly through high value added products such as infant formula.

Bega Cheese has been able to maintain its growth because of its strong brand and a move into high demand infant formula.

And a2 Milk Company hasn’t yet found a ceiling to demand for its infant formula. Profits for the half-year were up almost 800% to $NZ10.1 million as sales of the a2 Platinum infant formula, seen in Asia and China as clean and safe, exceed expectations.

But others have been caught in the downturn.

Murray Goulburn, Australia's biggest milk processor, says it will miss its profit forecast from its prospectus if there isn't a recovery in prices.

The company says China is buying 50% of what it used to.

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