News: UPDATE 1-New Zealand central bank flags dairy risk to lenders

• RBNZ says banks' earnings could be impacted
• RBNZ says banking system can withstand severe dairy downturn

(Recasts, adds detail about dairy sector, analyst comment, background)

The slump in global dairy prices could put pressure on New Zealand bank earnings under worse-case scenarios modelled by the central bank and released on Wednesday, as China's slowdown wreaks havoc on one of the country's top export earners.

The Reserve Bank of New Zealand said stress tests it conducted late last year showed banks would report losses ranging between 3 percent and 8 percent of their dairy exposure, depending on the severity of the price plunge.

"There is no doubt (the dairy sector) is highly leveraged and it is a structural risk," said Bernard Hodgetts, head of macro-financial stability for the central bank.

Banks have lent about NZ$38 billion ($25.13 billion) to farmers, representing 10 percent of their total lending in New Zealand. The five banks that were the subject of the stress tests represent nearly 100 percent of lending to the sector.

Any losses would likely be absorbed through lower bank earnings rather than an erosion of capital, the central bank said. Losses to the sector could range between around NZ$800 million and NZ$3 billion, according to Reuters calculations based on the central bank's figures.

The central bank's tests covered the New Zealand operations of Westpac Banking Corp (WBC), the Commonwealth Bank of Australia (CBA), the Australia and New Zealand Banking Group (ANZ), National Australia Bank (NAB) and Rabobank Group.

Global oversupply and falling demand particularly from China have seen dairy prices sink by more than half since early 2014. Until recently, dairy was the backbone of New Zealand's economy, representing around 25 percent of exports.

Omkar Joshi, investment analyst at Watermark Funds Management, said the dairy downturn could put negative pressure on bank earnings for some time to come.

"It really just comes down to how quickly the banks start to take the pain," he said.

The central bank noted that if prices remained below break-even levels for a prolonged period, banks could write off 12 percent to 25 percent of their dairy exposure. While they would then seek to offload those assets to recoup any losses, the scale of loans written off "would likely result in very challenging conditions in the market for dairy farms".

The banks should plan for the possibility that such write-offs could take longer than expected due to the depressed market in a worse-case scenario, it added.

STILL STRONG While the central bank flagged some risks it also said the banking system was robust enough to withstand a severe downturn in the dairy sector.

The stress tests asked banks to model two challenging scenarios.

Under the first, dairy prices paid to farmers in New Zealand remained below break-even levels until the 2017-18 season. Under the second, they did not recover until 2019-20. In reality, the central bank and other analysts expect dairy prices to recover sooner.

"New Zealand's banking system is robust to a severe dairy stress test," the central bank said. While the scenarios generated "significant increases in loss rates", they were "manageable for the banking system as a whole".

ASB Bank Rural Economist Nathan Penny said the report "reinforces our view that banks have the ability to look through the current dairy cycle and continue to provide cashflow support to dairy farmers".

The chance of the worse-case scenario playing out was less than 1 percent, he added. ($1 = 1.5124 New Zealand dollars)