Sunday, August 11, 2013

Fonterra a Perfect Example of Crony Capitalism

New Zealand faces a number of major economic risks with the world economy continuing to experience slow or no growth, but one of the worst is our dependence on the dairy industry.  This country of just over four million people has the largest dairy export industry in the world, accounting for around one third of global cross-border dairy trade.  It provides one quarter of New Zealand's merchandise export earnings, worth nearly $15 billion last year.  This is all good, I hear you say, and you'd be right except for one thing - the entire trade is controlled by one company - Fonterra.  

Fonterra traces its history to the formation of the New Zealand Dairy Board in 1930.  It is a cooperative structure, owned by its farmer suppliers.  From its beginning, the organisation has had a statutory monopoly on the export of dairy products and ownership is restricted to its farmer suppliers.  In 2001, the Dairy Board was merged with the two dominant cooperative processing companies, NZ Dairy Group and Kiwi Dairy Company to form a monolithic, vertically-integrated organisation that controls every aspect of production and distribution of New Zealand dairy products from the farm gate to the overseas supermarket.

The monopoly has produced two negative effects, both of which were predicted by those who opposed the 2001 merger - it has led to domination of the domestic market with correspondingly high prices for New Zealand consumers, and it has created a systemic risk of market and brand failure. The latter has been demonstrated twice in the last few years, both times in the lucrative Chinese market - firstly with the horrific 2008 scandal involving Fonterra subsidiary Sanlu that led to the deaths of six babies and the hospitalisation of 54,000, and most recently with the Chinese suspension of imports of Fonterra's milk and whey powder due to botulism.  As this article in Bloomberg points out, the impact of this latest incidient is likely to go beyond Fonterra and the dairy industry. It has already led to a decline in the New Zealand Dollar and knock-on bans in other countries such as Sri Lanka.   

The failure of one company ought not to affect an entire economy.  In a competitive market, other companies with equally strong brands would be largely unaffected and would step in and fill the gap in exports caused by the failure of the offending brand.  This cannot happen with New Zealand dairy exports because of Fonterra's statutory monopoly.

Contrary to popular belief, monopoly is not the natural end-state of capitalism.  Monopolies may occur in a totally free market but only where the dominant player has some huge competitive advantage such as control of critical patents, and even then such monopolies are usually short-lived. Perhaps the greatest monopoly of the them all was John D Rockefeller's Standard Oil but even his monopoly wasn't absolute and was relatively short-lived - being confined to lighting oil in the late 19th Century. Contrary to popular belief, the end to Rockefeller's monopoly didn't come from the US antitrust Sherman Act enacted in 1906 (although this was vindictively used to break up his company) - Standard Oil's dominance was already being eroded by the innovation of electric lighting and the development of new oil products for automobile fuel.  In a free market, all monopolies are short-lived because they can never counter all the likely sources of innovation over the long term. We have seen this with Microsoft, which has not been able to extend its dominance in desktop PC software to the new markets for smartphones and tablets.

The one situation where monopolies do thrive, however, is when they are government-mandated.  The only reason Fonterra and its predecessors have monopolised the New Zealand export dairy market for so long is their legislative protection.  A free market might have produced a dozen Fonterras by now.  If you want to see the potential, you need only look at another dairy cooperative in another country that was set up at the same time - Nestle in Switzerland.  Nestle has grown without the legislative protection of Fonterra to be a highly-diversified food manufacturing company and one of the best known brands in the world.  Fonterra by comparison, has remained largely a commodity producer.  A ban on the import of Nestle milk powder products to China would have minimal effect on the whole of Nestle's business and would be virtually unnoticed in Swiss export trade figures.   

We seem to especially like government-mandated and government-owned monopolies in New Zealand. Our energy, transport and accident insurance markets are totally dominated by such structures.  We pretend that these monopolies are the best for New Zealand but we never try to assess the opportunity costs.  It is no surprise that we have no other large, internationally-competitive private sector companies of the scale of Fonterra. So much of our capital stock in tied up in these protected, crony capitalist entities that there is little incentive or appetite to make New Zealand the home of an Apple, Nokia or Ikea. Perhaps that is one of the reasons New Zealand continues to languish at the bottom of OECD income-per-capita tables. 


Mark Hubbard said...

Very good piece. Hope you don't mind if I link to blog post I'm putting up tomorrow?

Ratbert said...

FYI, Nestle is not a cooperative and never has been and contrary to your article a brand recall of Nestle brands in China in fact has already had a huge impact on the company. Culminating in having to spend $12 billion USD just to buy back market share in the Chinese Infant formula market 8 years later!!

Kiwiwit said...

Mark, not at all.

Kiwiwit said...

Ratbert - I understood Nestle originally had a cooperative ownership structure. In any event, Nestle turns over nearly $100B p.a. so your $12B over 8 years is around 1.5% of turnover. The point is the dependence of the entire NZ economy on Fonterra likely would not exist if it weren't for its legislative mandate.