Is the Canadian agriculture falling into a debt trap?

With agricultural commodities prices falling and the prospect of rising interest rates getting closer, I thought it could be interesting to see where the Canadian agriculture stands debt-wise. In this post, I will look at the indebtedness in two ways.

Firstly, farm indebtedness will be assessed relative to the output of the Canadian agriculture. We start by deflating the farm debt value by the CPI. The output is derived from the value of the production (farm sales and change in inventories) by deflating it by the farm products price index. By building an index, we are able to obtain the change in our ratio [Farm debt / Output].

We do the same with the Gross value added (GVA) of the Canadian agriculture and the total value of farm assets (real estate and quota).

The first graph below presents the evolution of our three ratios. What really stands out is:

  • the significant decrease of the economic efficiency (GVA/Output) of the Canadian agriculture over the period considered here (1981-2014) though it has bounced back a bit over the last 10 years thanks to high prices.
  • from 1995, the divergence of dynamics between, on one hand indebtedness and farm assets value, and on the other economic efficiency.

debt trap CDN_AG

That could be explained mainly by two factors :

  • lower interest rates which are now close to the lowest level they could reasonably be at;
  • the increasing share of off-farm income in the farm households which is not captured by the GVA account, and that provides liquidity to repay debt obligations

Secondly, we will look at the indebtedness in the Canadian agriculture through the ratio (Farm debt outstanding)/(Maximum farm debt).

Maximum farm debt is defined as the long-term debt allowed by the aggregate debt servicing capacity, assuming terms and conditions complying with current best agricultural lending practices:

  • Debt service coverage ratio of 1.1, calculated as Earnings before Interest, taxes, Depreciation and Amortization (EBITDA) divided by Principal plus Interest payment. Using Statistics Canada data, EBITDA is approximated by Net cash income plus interest. Because of the intrinsic volatility of farm income, we will use a 3-year average of net cash income before interest in place of the current value to calculate our debt repayment capacity.
  • Repayment period based on useful life of assets. Usually, it is based on the weighted average of the useful life of the different asset classes. However, in order to assess the maximum level of debt, we could use a 20-year repayment period providing the ratio Maximum debt to total Land value remains below 75%. If that ratio was to be above 75%, we would have to revert to the weighted average, with 15 years a good benchmark.
  • Prudent interest rate: the 5-year conventional mortgage rate which is commonly used to stress-test credit risk of agricultural loans. Comparing it to the apparent average interest rate paid by farms, we could note that from the mid-90’s, the spread between the two interest rates is relatively stable.

The graph below shows that indebtedness capacity became more and more saturated until 2005-2007. Then, lower interest rates, increasing farm products and farmland prices, all contributed to raising the maximum farm debt.

max debt + scen

We note that two provinces stand out : Saskatchewan and British Columbia (BC). The former has experienced a remarkable drop in indebtedness saturation because all the recent trends mentioned previously were amplified here. The latter, a contrario, has experienced a very significant jump with a current indebtedness saturation of more than 100%. How is that possible? Short answer: off-farm income, low interest rate, non-standard lending term and conditions, farmland prices driven by non-agricultural factors.

Now, we will assume that the interest rate gradually reverses to its 20-year mean over 10 years while debt repayment capacity, farm debt and land value remain constant. That sole change would lead to increasing saturation of the indebtedness capacity. However, we could construct realistic scenarios which would lead to a much faster saturation.

As far as I am concerned, the debt problem of the Canadian agriculture is not a problem of solvency. The Canadian agriculture is solvent. I do not foresee any collapse of crisis-scale within the next decade. It is a problem of restricting the ability of the Canadian agriculture to sustain, over the long term, a level of investment consistent with the competitive pressure, the pace of innovation and of demographic change.

Then, questions come to mind: Why debt? Are there other sources of capital available? 

This is a first-level analysis at a very aggregated level. To assess the risk identified here adequately, we need to dig deeper and go to disaggregated levels. Preliminary results show differences along industry and farm-size lines.

A look at Quebec agriculture and some questions about its future

A pdf version with illustrations can be found here : A look at Quebec agriculture and its future.

The period 2007-2012 saw tremendous changes. The financial crisis of 2008-2009 has led to an exceptional environment of low interest rate, which, in Canada, has been coupled with a relatively open access to credit thanks to the strength of Canadian banks. Meanwhile, the evolution of the fundamentals of agricultural commodities markets has translated into a regime of historically high prices. This has created a very peculiar situation which may determine the possible trajectories of Quebec agriculture into the future.

First, we will have a look at how Quebec agriculture evolved over the 1991-2012 period with respect to its aggregate financial situation, based on data from Statistics Canada. When charting the evolution of farm cash receipts, farm debt, farm assets value and aggregate EBITDA (Earnings before Interest Taxes Depreciation and Amortization), and of the value of farm assets , all expressed in chained dollars (2007), the most striking elements are :

i) the relative flatness of EBITDA expressed in chained dollar,

ii) the significant increase of assets aggregate value and debt especially over the 1994-2002 period,

iii) the decrease in interest rate.

The 1994-2002 period saw the remarkable development of hog production in Quebec thanks to a concerted effort of all stakeholders. Besides, it is during that same period that the quota markets of supply-managed production experienced a fundamental change when quota became an asset that could be pledged for financing purpose. Initially amortized over 5 years, quota quickly got to 7, 10 and finally 12 years amortization. This, coupled with decreasing interest rate, led to an easy access to credit, driving quota price up as most of the purchases were marginal in nature.

Analysing the EBITDA margin ratio (EBITDA / Farm cash receipts), we note a decrease over time. This has only be reversed slightly over the last 5 years with farm product prices reaching historically high levels. Farm input prices have outpaced the increase in farm product prices most of the time. Then, efficiency gains have not been enough, or just helped, to cover the increase in input costs.

Meanwhile, the ratio Debt / Farm cash receipts has steadily increased along with the ratio Debt / EBITDA. Yet, thanks to the jump in agricultural products prices after 2007, the upward trend for both ratios has stalled but the underlying level of debt is still high.

To clearly see the extent of the impact of these high prices, we have estimated the growth of the physical output in Quebec agriculture. We note several noteworthy trends. First, the most remarkable one is the divergence of the pace of growth of the balance sheet (debt and assets) from farm sales, starting in 1997. In the meantime, overall output growth has been held back since 2007 mainly because aggregate output from livestock productions has not seen any growth.

To put things into perspective, we could calculate the impact of a simultaneous increase of interest rate and decrease in farm cash receipts assuming 2012 farm output and 2012 farm debt.

If farm product prices were to be on par with the average of the 2010-2012 period, then farm sales (excluding direct payments and based on 2012 output) would decrease by 5.5%. Based on a similar price context, we will assume that direct payments represent close to 10% of the farm sales. So overall, farm cash receipts would be 6% lower and consequently EBITDA would be down by almost 20%.

Now, if the average interest rate was raised by 100 bp (1%), interest expenses would be up by 25%.

Combination of both shocks would result in the net cash income generated by Quebec agriculture decreasing by 29%.

What could we say of today’s Quebec agriculture ?

Its aggregate output is not growing.

Its efficiency has been declining for a long period of time.

Yet, its balance sheet has grown tremendously.

Hence, it may be overly exposed to any increase in interest rate and/or reduction in farm product prices.

All this is raising a few questions about the future of Quebec agriculture.

How long may this unique combination of high farm prices and low interest rate last ?

We have shown that simultaneous shocks for both variables would have a marked impact on Quebec agriculture. So, answering that question is key in assessing the risk of a severe downturn for Quebec agriculture in the foreseeable future. This is even more relevant when only considering the additional capital that will be required to ensure the transfer of assets from exiting farms, either to the next generation or to existing farms.

How can Quebec agriculture increase its output ?

Demographics and consumption patterns may impose some drag on dairy and poultry production. There would be some opportunities for the beef industry if only it could structure an actual value-chain. Crops have seen some dynamism and there is some room left for growth. As to Quebec hog production, output growth will be determined by the ability of meat processors to grow market share domestically and abroad which in turn questions the competitiveness of hog producers.

How can Quebec agriculture increase its efficiency ?

Answering that question will obviously be different from one production to the other. However, it will most certainly require investments to reach the right combination of economies of scale, of innovation in production [productivity], marketing [adding value] and management.

However, there may be some uncertainty as to the remaining financial capacity to invest within Quebec agriculture ? Are there enough farms able to carry on these investments ? If so, what could be done to strengthen them ? If not, what would be the consequences of a smaller agriculture in Quebec ?

This has already been said by many : Quebec agriculture needs a vision, a strategy, and a proper public policy to support it.

About the future of supply-management and the difficulty to debate it.

After some discussions, it appears that my previous post on supply management (here) has been understood as a manifesto for dismantling supply management. Yet, nowhere in that post, did I convey such opinion. What I wrote is that current dynamics, if not addressed, may lead to the implosion of supply management. So, let me just rephrase my rationale and clarify some of its elements.

Before anything else, we must acknowledge the successes of supply-management for the Quebec economy. The average income of Quebec dairy farmers’ families is now above the average Canadian family, as is their net worth (see table below). Saputo and Agropur have become world-class dairy processors with a global footprint. The milk is of the highest standards of quality and safety. But when looking at the future, one can see some clouds gathering.

income and wealth dairy farmers QC

First, the quota market is currently not allowing any meaningful investment to fulfil the potential productivity and efficiency gains at the farm level. For Quebec, this means that the efficiency gap with other provinces will increase. In the meantime, although there has been a unique opportunity to deleverage, debt is still growing in dairy farms as excess liquidity is directed to non-dairy investments such as farmland. So, we see, on one hand, assets that are accumulating within farms waiting for the right time to exit and, on the other hand, farms turned towards the future that are investing in non-dairy assets and taking on more debt.

When the time will come to re-invest in dairy production, the scale of investment will likely be large (modernization, farm transfer, etc.). Do we know for sure that the farms we think will take on most of these investments will be able to do so ? I do not have a definitive answer to that question but I’m sceptic because, from my time in banking, I remember that the most efficient farms have been among the most leveraged. While they will certainly have some spare capacity to invest, I question the adequation of their aggregate investment capacity to the scale of the investment that will be needed.

That inadequation would become apparent if a major event was to happen, resulting in a significant increase in cost (major drought leading to insufficient feed availability) or fall in price (major disease outbreak linked to popular dairy products). Then, the number of exiting farms may jump dramatically requiring the farms left to take on the missing production capacity over a relatively short period of time. Consequently, I think there is a risk to see production below demand long enough that the processors would have no choice but to import from other provinces (the least damaging to supply-management at the national level but not for the Quebec share of quota) or from the US (once the gates are open…).

Leaving the worst-case scenario aside and considering a more gradual exit of the less efficient farms, the capacity of dairy farms to invest will still be mainly determined by their capacity to take on more debt. And that could happen in a context where there will be pressure to temper milk price increase and where interest rate will increase in all likelihood. It is also worth remembering here that any decrease in quota value may make it more affordable but it also may also markedly decrease the net worth thus limiting the borrowing capacity of farms, especially in cases where the quota had been leveraged a bit too much.

Perhaps all this is far-fetched and I may end up completely wrong. Yet, I have not read or heard anything to convince me there is no risk.

If I had to suggest a way to reform supply management in the dairy industry, I would choose one based on the deregulation of the quota market along with the creation of regional markets and with a cost-of-production benchmark excluding a greater proportion of the less efficient farms. I would add another measure to prevent any lasting overpricing of quota (and the related risk of over-indebtedness) that is to set up limitations in the use of quota as a collateral in credit structuring.

Supply management needs to be reformed and that rethinking might also extend to the objectives of supply management themselves. Quebec, Canada and the world have changed, the dairy industry has changed and so will supply management. This is not a question of ideology ; this is a question of being realistic.

I’m asking these questions because I see a risk that could be managed. I would not mind coming to the conclusion that there is a trajectory for supply management to last and be able to support prosperous dairy farms and processors for another generation. But I maintain that these issues need to be investigated more thoroughly in order to better anticipate the coming of the black swan that will provoke the demise of supply management. Here comes to mind the Titanic, unsinkable until it met an iceberg.

Sometimes it feels as supply-management is a dogma and not a public policy that could be debated and reformed. We should remember that history offers plenty of examples of such dogmas relegated to the museum of ideas.