3.3 Increased demand for dairy products

China currently has a level of per capita dairy consumption well below the world average, even allowing for its low income level, leaving room for it to grow as incomes increase (Figure 6). Research has shown that dairy consumption has a high income elasticity when compared to other food products, especially for low income countries (Gerosa and Skoet, 2012). Gerosa and Skoet estimate that for low income countries a 1% increase in income leads to a 0.8% increase in expenditure on dairy products. As incomes grow, this elasticity declines, but at a lesser rate than for other food products. Meat, which is New Zealand's third largest product export to China, has the second highest income elasticity of the food products studied. This shows there is still significant room for increased dairy demand, as incomes grow and diets become more closely aligned with developed countries in the future, providing benefits for New Zealand exporters.

Figure 6 – Dairy consumption vs GDP

Sources: OECD-FAO, World Bank

Dairy product demand will also be supported by increased urbanisation in coming years. Milk consumption per capita in urban areas was 13.7kg in 2011 versus 5.2kg in rural areas(OECD, 2013), showing that as more people move into urban areas, overall dairy consumption will rise. Meat and poultry consumption is also significantly higher in urban households. Government guidelines recommend the consumption of milk in China and programmes are in place to promote the consumption of milk in schools. If Chinese per capita consumption rose to match that of Taiwan, a market with similar tastes and geographical location but much higher per capita incomes, China would increase global milk and cheese consumption by more than 10% and 15% respectively (Matthews, 2010).

According to the Food and Agricultural Organisation, in conjunction with the OECD (OECD-FAO, 2012), the only dairy product that China consumes on a level comparable to other similar countries is whole milk powder (WMP) (Figure 7.1). China is the world's largest WMP importer and New Zealand the largest exporter. China's skim milk powder (SMP), butter and cheese consumption per capita is at a level much below other more developed countries. Per capita consumption of SMP, butter and cheese tends to increase as per capita GDP increases (Figures 7.2, 7.3, 7.4) showing there is plenty of room for Chinese consumers to increase their consumption of dairy products as their incomes continue to grow.

Figure 7 – Dairy consumption per capita

Figure 7.1:  WMP consumption per capita

Sources: FAO, Treasury calculations

Figure 7 – Dairy consumption per capita (continued)

Figure 7.2:  SMP consumption per capita

Sources: FAO, Treasury calculations

Figure 7 – Dairy consumption per capita (continued)

Figure 7.3:  Butter consumption per capita

Sources: FAO, Treasury calculations

Figure 7 – Dairy consumption per capita (continued)

Figure 7.4:  Cheese consumption per capita

Sources: FAO, Treasury calculations

Of the various dairy products, China's consumption of SMP and cheese are most likely to increase in the near term, as China is well behind other countries with similar culture and income levels. Japan and Korea have SMP and cheese consumption per capita that is five times greater than China. If China follows a comparable path to Korea or Japan, its consumption of SMP and cheese will grow significantly in coming years as its GDP per capita grows (Figure 8).

If China's SMP consumption per capita grows to the level of Taiwan, it would increase world SMP consumption by 34%. New Zealand is the second largest SMP exporter in the world, with around a 23% share of world trade, and would stand to benefit from this increase to the extent that it is able to increase its dairy production. In some cases a fall in WMP consumption provides an offset to rising SMP consumption as incomes rise, although the OECD-FAO still expects WMP consumption to rise in coming years. The countries most similar to China in terms of income, Thailand and Algeria, also have higher dairy consumption per capita.

Figure 8 – Dairy consumption per capita

Figure 8.1:  China, Japan and Korea SMP consumption and GDP per capita

Sources: FAO, Treasury  calculations

Figure 8 – Dairy consumption per capita (continued)

8.2:  China, Japan and Korea cheese consumption and GDP per capita

Sources: FAO, Treasury  calculations

These factors lead the OECD-FAO(2012) to project that Chinese dairy consumption growth will outstrip production between 2012 and 2021. The net importation of dairy products is expected to increase by around 60% between the 2010-2012 base period and 2021. They project that WMP, SMP, butter and cheese consumption per capita will increase 2%, 3%, 1% and 3% respectively per annum over the next decade. This rising per capita consumption, along with the inability of production to keep up with consumption and growing concerns about the quality of domestic production, will require China to import product to make up the shortfall. It is projected imports of WMP, SMP, butter and cheese will increase 14%, 47%, 13% and 135% respectively over the next decade.

Even since the 2008 melamine scandal, nearly 300 tonnes of contaminated product has been detected. The Chinese State Council has since implemented stricter quality controls, which may increase the demand for imported products, unless local production complies with the new regulations. Indeed, new regulations forced the closure of a significant portion of small Chinese dairy processors in April 2011. These tighter regulations will increase costs and force more small producers out of the market. These factors will likely see increased demand for high quality imported dairy products. The production chain was reformed following the scandal and this is likely to contribute to slower domestic production growth. In addition, local production may be constrained by animal diseases, including foot and mouth for which nine provinces have officially reported outbreaks.

New Zealand is the world's largest dairy exporter, is known for its high quality products and already has well established supply chains into China. New Zealand currently supplies the majority of Chinese dairy production shortfall. Also, New Zealand has an advantage over most other countries in the world when it comes to dairy production, with significant endowments of water and land suitable for dairy. New Zealand has 77,336m³ of renewable water resources per person, compared to China which has only 2,134m³. Only 1% of New Zealand's renewable water supply is used by agriculture, compared to 13% in China(World Bank, 2011). However, New Zealand does face challenges around the quality and availability of water.[42] These factors suggest that New Zealand will continue to provide a large portion of China's increased dairy imports in the future. This may require some reallocation of dairy exports from other export markets if dairy production does not increase sufficiently in New Zealand.

While dairy production is fairly fixed during any given year, over a longer horizon it can increase to meet growing demand. The Ministry for Primary Industries (MPI) expects production to increase by 3% per year from 2015 to 2017 as cow numbers and milk solids per cow increase gradually(Ministry for Primary Industries, 2013). The OECD-FAO expects NZ milk production to average 2.3% annual growth between 2011 and 2020, while Fonterra expects New Zealand milk production will be able to grow at around 3% per annum, through growth in herd size and productivity gains (Fonterra, 2012).

If milk production increases 3% per annum it would add around 0.1 percentage points to GDP growth, given the dairy industry is around 4% of the economy. This would allow New Zealand production to keep up with increased demand from China. Even in the absence of increasing total export volumes, dairy prices are likely to stay high as China continues to dominate the world market with demand for high quality imported dairy products.

Fonterra estimates that global milk production can grow at around 2% per annum (slightly slower than New Zealand's production) until 2020, not sufficient to keep up with growing global demand of around 3%. This is mainly driven by China's 7% annual demand growth outstripping its 4% supply growth (Fonterra, 2012). The OECD-FAO also forecasts prices to remain high as the result of strong global demand growth putting pressure on supply. The pressure on supply comes from biological constraints, limited productivity growth in developing countries and lack of arable land as industrialisation takes away potential land.

As incomes grow, Chinese consumers will be willing to pay higher prices to secure quality food products as a lot of people do not trust the quality of locally produced product. The OECD-FAO expects that dairy prices will increase gradually in nominal terms out to 2022 as demand in developing economies outstrips the supply response in those countries, increasing import demand. This will result in prices in real terms being significantly higher over the next decade than in the previous decade. MPI also expects dairy prices to gradually increase in nominal terms out to 2017 (Ministry for Primary Industries, 2013).