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COMMENTARY & ANALYSIS

October 12, 2019

Rising consumption, slowing growth, accelerating imports keynote Chinese dairy sector growth

The world's leading buyer of commodity dairy powders, China is now a top importer of higher value-added dairy goods such as butter, cheese, pasteurized milk and yogurt.

By Eric J. Brooks
 
An eFeedLink Hot Topic
 
 

China's dairy sector is prosperous, profitable, but increasingly dependent on foreign suppliers and investments in overseas facilities.
 
The good news is that high domestic milk prices are stimulating a 2.3% increase in 2019's fluid milk output, to a USDA estimated 33 million tonnes. The bad news is that even though per capita fluid milk demand has doubled from 18kg in 2009 to 36kg this year, output is only 5.6% higher than it was in 2008, when the melamine contamination scandal came to light; and remains 3% below 2012's 33.11 million tonne record.
 
On the other hand, productivity has been rising by 4% annually and consumption growth recovered from its mid-decade pause, which induced a dairy market crash demand. Even so, the industry is now pulled forward by new growth locomotives. Demand for fattier, value-added consumer dairy products is outstripping capacity growth and high domestic production costs, making for rapid imports of everything from fresh milk to cheese, butter to dairy beverages.
 
Flat milk production also reflects the speed of industry consolidation, where large, rapidly expanding dairy operations have barely kept pace with the elimination of smaller farms. From a peak of 114,000 in 2011, the number of dairy farms with fewer than 300 head of cattle fell to 56,000 in 2018. Partly due to high land prices due to encroaching urbanization, the total number of dairy farms within 100km of Beijing, Shanghai and Tianjin has fallen by 46% to 51%.
 
Amid near-constant fluid milk output, the number of dairy cattle fell 20%, from a USDA estimated peak of 15 million head at the start of 2014 to 12 million head at the start of 2018, staying constant at that number this year. It means that each dairy cow will produce almost 25% more milk this year than it did in 2014. This reflects the importation of superior dairy cattle genetics, which are being complimented by higher quality feed and improving farm management.
 
 
Dairy processing has also consolidated, with the top eight processors now collecting over 70% of China's fluid milk output. Consolidation is even more prominent at the supply chain's value-added end products. Five dairy processors for example, account for 90% of both domestic cheese production and imports. Rising oligopoly power and a willingness to substitute imported WMP and SMP in place of domestic fluid milk enable processors to demand lower milk prices than they did in the past.
 
Nevertheless, high feed costs and limited milk production make the industry incapable of fully satisfying both consumer and dairy processing demand. Hence dairy suppliers increasingly satisfy rising consumption through steady import growth. –But it is a different sort of import growth than before 2014's dairy market crash.
 
Whereas that era's dairy boom was defined by rapid growth in raw commodity powders used in domestic processing, import growth is now led by finished, higher-value goods, many of which are directly consumed by the public.
 
Whereas commodity dairy powders drove import growth prior to 2015, both WMP and SMP consumption remain well below pre-dairy crash peak levels. On the other hand, with their domestic output well below their mid-decade peaks, WMP and SMP imports are approaching historic peak levels –but have not yet surpassed volume records set in 2014.
 
Instead of leveling off from 470,000 tonnes in 2017 to a forecasted 460,000 tonnes last year, 2018 WMP imports unexpectedly increased 10.9%, to 521,000 tonnes. Defying the original 500,000-tonne prediction, 2019 WMP import growth will accelerate further, rising 15.2%, to a USDA estimated 600,000 tonnes. Even this, however, is well below the record 671,000 tonnes WMP import volume set in 2014, before faltering Chinese dairy powder demand crashed prices.
 
Import growth reflects the fact that since 2017, domestic WMP output has stayed flat, falling a marginal 10,000 tonnes or 1% to 965,000 tonnes in 2018. This is far lower than the 1.3 million tonnes forecast for 2019 by the USDA. Low production is due to low international WMP prices, which undercut domestic WMP by RMB10,000/tonne (US$1,500/tonne).
 
With foreign WMP having a two-year shelf life and domestic supplies going stale after just one year, this too motivates the WMP imports, which accounted for 34% of 2018 consumption.
 
On the other hand, the past two years have seen WMP consumption rise by 4.7% from 1.49 million tonnes in 2017 to 1.53 million tonnes in 2019 and 1.56 million tonnes this year. New Zealand accounts for 88% of WMP shipments, followed by Australia's 2% and another 10% divided up between several EU nations, America and Paraguay.
 
Domestically produced WMP is used to address a structural market imbalance: China's perishable milk is mostly produced in one half of the year but peak seasonal consumption occurs six months later, necessitating its preservation by conversion into WMP and subsequent re-hydration.
 
On the other hand, while 2018 saw SMP finally equal its 2014 consumption peak of 300,000 tonnes, SMP imports are growing far more rapidly and domestic output falling more steeply than is the case for WMP.
 
Used interchangeably with WMP in many food products, SMP has been selling at a 15% to 35% discount to WMP for most of the last three years. SMP's relatively low import price discouraged domestic production while encouraging its importation, as it was less costly than WMP. Hence, this year will finally see SMP consumption and imports marginally exceed their 2014 peak while WMP demand remains well below former levels.
 
New Zealand (45%) and Australia (12%) supply a majority of SMP. Their lower production and transport costs make it less expensive than supplies from the EU (34%) or America (8%), with the latter facing a 25% import tax.
 
On the other hand, due to their relatively flat fluid milk output, Australia and New Zealand cannot offer China as much SMP as it would like to buy. America could provide it a new source of SMP supplies but is blocked by a 25% import tariff.
 
Hence, after rising 13.4% from 247,000 tonnes in 2017 to 280,000 tonnes in 2018, Chinese buyers will only be able to source 8.9% more SMP or 305,000 tonnes this year, though they would have preferred to import more SMP and less WMP if they could.
 

Compared to flat or slow-growing dairy powder imports, fattier or consumer-oriented dairy goods that have undergone value-added processing now lead the import parade.
 
This can be seen in foreign UHT milk's popularity, particularly among higher-income consumers, who tend to shun domestic milk due to safety concerns. From 10,000 tonnes in 2008, UHT milk imports skyrocketed before stabilizing in the 650,000 to 675,000-tonne range after 2015, as per capita consumption in larger Chinese cities approached saturation levels. In particular, residents of large cities are now substituting imported fresh pasteurized milk in place of their previous UHT purchases.
 
This year however, UHT milk imports will total 750,000 tonnes and expand by 11.4%, as improved transport and logistics infrastructure make them available in small remote cities and adjoining rural regions. With cold chain infrastructure now expanding into third and fourth-tier cities and adjoining rural areas, fluid milk imports are growing strongly again but will gradually decelerate in the 2020s.
 
Northern EU nations including Denmark, France, Belgium and Germany supplied 52% or 350,000 tonnes of 2018's fluid imports, with Germany alone accounting for 25% or 168,250 tonnes. The largest single market share however, belongs to New Zealand.
 
New Zealand also leverages its geographic proximity to China to easily export a large proportion of perishable, time-sensitive but increasingly popular pasteurized milk. This along with a recent free trade agreement allows New Zealand to supply 35% or 236,000 tonnes of China's 2018 fluid milk imports. Australia 80,000 tonnes accounts for most of the remaining 13% of China's foreign milk, though a serious, multi-year drought constrains its capacity to export.
 
Over the long run, the size and character of China's appetite for fluid milk will be driven by two factors. First, rural residents still drink 60% less milk per capita than urban dwellers. Second, pasteurized milk accounts for 14% of Chinese fluid milk consumption, versus 99% in nations such as America or Australia.
 
Fast-rising rural consumption will keep fluid milk imports growing for many decades. The expansion of cold chain facilities into rural regions will eventually make pasteurized milk account for an ever-growing share of China's fluid milk imports. New Zealand's geographic proximity gives it an advantage in supplying China perishable, time-sensitive pasteurized milk.
 
But fluid milk is just the tip of the iceberg in China's value-added dairy market. On one hand, despite an exponential increase from 1,300 tonnes in 2010 to 10,000 tonnes in 2015 and a USDA estimated 40,000 tonnes this year, China's yogurt imports are only 5% of its fluid milk imports by weight –but at a US$17 billion, yogurt sales surpassed those of fluid milk by revenue in 2017 –even though yogurt consumption by volume is a tiny fraction of fluid milk consumed.
 
China's shift toward value-added consumption can also be seen in the growing importance of cheese: Based on USDA interviews with industry sources, revenues from cheese will expand from US$790 million this year to US$1.5 billion by 2024.
 
The rapid rate of revenue growth implies that physical cheese consumption is growing by at least 10% to 12% annually and is mostly done outside the home. This is because rather than being consumed on its own, most cheese is incorporated into the burgers, pizzas and other food items sold at fast-food restaurants, bakeries and hotels.
 
All this stimulates cheese production and import expansion even more so, with approximately 75% of consumption accounted for by imports. From less than 2,000 tonnes in 2000, domestic cheese output will total 40,000 tonnes in 2019. Imports grew even more rapidly, from 20,000 tonnes in 2010 to 76,000 tonnes in 2015 and a USDA estimated 119,000 tonnes this year.
 
Mozzarella, cheddar and cream cheese account for most consumers. Import-wise, New Zealand (51%) accounted for a majority of foreign cheese purchases by volume, with Australia (18%), the EU (17%) and the United States (11%) accounting for most of the rest.
 
While New Zealand and Australia can boost export volumes by enough to cover a steep drop in US cheese imports (which are now face a 25% tariff), their own ability to satisfy Chinese demand is also constrained by their static dairy herd size. Consequently, unless China and America resolve their trade war differences, we can expect a rising proportion of China's cheese imports to come from Europe or Latin America.
 
Along with cheese, China's appetite for fatty dairy goods is also mirrored in its relentless growing appetite for butter, which has seen its consumption jump 733% over ten years, from approximately 15,000 tonnes in 2009 to 125,000 tonnes this year. With milk production only increasing by 5% over this decade, almost all the demand growth was met by imports, which skyrocketed from 15,000 tonnes in 2010 to 76,000 tonnes in 2015 and a record 113,330 tonnes in 2018.
 
Constrained by expensive domestic milk feedstock whose production has barely expanded for a decade, China's 10,000-tonne domestic butter output was used by bakeries, hotels and restaurants, as is most imported butter. While very little butter is used directly by consumers at home, this market segment is also imported, with some being re-packaged and sold under local Chinese brand names.
 
Due to its geographic proximity, low production and shipping costs, New Zealand has always supplied approximately 85% to 90% of Chinese butter imports, with the EU and Australia providing most of the rest. This was also true in 2018, when New Zealand shipped China 100,444 tonnes of butter, followed by the EU's 4,518 tonnes, Australia's 1,965 tonnes 6,400 tonnes from other nations.
 
For 2019, poor dairy cattle pasture conditions mean that China will not be able to fully counterbalance up a shortfall in New Zealand butter production by importing from other nations. With US cheese made too costly by a 25% tariff, import volumes will drop 3.5%, to 109,000 tonnes.
 
Even so, the overall pattern is quite clear. From almost nothing ten years ago, China is now the world's second-largest butter importer, second only to Russia's 120,000 tonnes and importing almost as much as Mexico, Australia, the EU and Japan combined. It will soon be the world's largest butter importer.
 
From almost nothing fifteen years ago, it was the fifth-largest cheese importer in 2018. It is on track to overtake top three cheese importers Russia, America and Japan within a decade.
 
Constrained by everything from scarce, expensive feed to a bad reputation among consumers, China's dairy producers have reconciled themselves to the reality that pre-2008 days of 10%+ annual expansion in Chinese milk production will not return –but that consumption will continue expanding aggressively.
 
And they have adjusted their investment strategy accordingly: Unable to economically produce everything Chinese consumers want at home, they are expanding their control over foreign suppliers.
 
For example, early 2010 saw leading Chinese dairy producer Yili acquire control of Westland, New Zealand's second-largest dairy co-operative.  Already exporting most of Westland's production to China or Southeast Asian nations such as Singapore and Malaysia, Yili promptly announced its intention to expand Westland's export-oriented butter, WMP, SMP, pasteurized and UHT making capacity.
 
In everything from oil production to pork processing, Chinese overseas investment has always run counter to the flow of vitally needed imports. Do not be surprised if your favorite western supplier of milk, butter, yogurt or cheese gets an offer it cannot refuse from a well-capitalized Chinese dairy distributor with big ambitions.
 


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