What Traders Need to Watch in the Canada Dairy Dispute

(Bloomberg View) -- Last week, President Donald Trump accused Canada of taking advantage of U.S. dairy farmers. The behavior of the U.S.'s northern neighbor "is a disgrace," he told reporters.

Despite the harsh words, it remains to be seen how closely Trump plans to match his rhetoric with action. This week, he said he had decided to delay making good on a campaign promise to withdraw from the North American Free Trade and will seek to renegotiate the pact instead. The dairy dispute, even though it shouldn't justify the end of Nafta, deserves to be negotiated and Trump is right not to accept the status quo.

Americans have long complained about Canadian dairy production. Over the past year, U.S. lawmakers have had extensive communication with their Canadian counterparts, and with Prime Minister Justin Trudeau and his cabinet over the country's dairy pricing policies. Even former President Barack Obama privately complained to Trudeau that Canadian policies were harmful to U.S. exporters. To no avail.

Canada's dairy and butter represent a mere .97 percent of global production and dairy milk (fluid) only 1.56 percent. Nevertheless, trade in these products between the U.S. and Canada is meaningful. In 2016, according to Canadian government data, that country imported C$557 million ($413 million) in dairy products from the U.S., while C$113 crossed the border in reverse, creating a C$445 million deficit.

The argument focuses on what is known as ultra-filtered milk. In May 2016, the Canadian Dairy Commission modified the 4M milk class to enable all its processors to buy a liquid, high-protein concentrate used in the manufacturing of cheese and yogurt, instead of imported milk protein concentrates -- known as MPCs or ultra-filtered milk -- effectively displacing imports.  

Although the policy entailed a heavy domestic subsidy cost, it lowered the prices for this milk class to create incentives to produce domestic ultra-filtered milk and better compete with U.S.-produced imports. Although still labeled a temporary program, the 4M milk class was extended to run until early 2017 with no termination date. Agropur, a major Canadian cooperative owned by Quebec-based farmers with holdings including cheese and whey operations in the U.S., stated in May 2016 that it would cease to import any ultra-filtered milk sourced from the United States. Meanwhile, dairy production in Canada increases.

The U.S. dairy industry argued that the policy violated Nafta by creating incentives for Canadian processors to use local supplies, effectively blocking U.S. dairy exports, and directly causing a glut of U.S. milk supplies. Yet the Canadian dairy industry, in defending its milk reclassification policy, indicated the product was duty-free, quota-free, did not impose any import taxes, and thus did not break any import rules. 

Trump's advisers are deeply divided over how aggressively to erect trade barriers. This dispute, nevertheless, is oddly bridging traditional party lines and creating an unusual alliance between Trump; New York's Democratic governor, Andrew Cuomo, and its senator, Chuck Schumer; Wisconsin's Republican governor, Scott Walker; and U.S. House Speaker Paul Ryan.

Cuomo beseeched Trudeau to develop a national agreement averting a $50 million market loss for New York's dairy industry. Even Schumer, who has a contentious relationship with Trump, tweeted praise for the president's get-tough approach to Canada.

Source: USDA (includes only milk and no byproducts)

The U.S. dairy industry has other reasons to be wary. Dairy inventories are rising as prices drop. U.S. milk production has increased from 193 billion pounds to 199 billion pounds from 2014 to 2016, whereas U.S. prices have dropped from $24.00 per hundred weight to $13.14 in that period. Over the last decades, milk sales have been as lumpy as cottage cheese and in recent years have nosedived, as have the prices of futures.

Additionally, the strong U.S. dollar has been an impediment to exports. The U.S. is among the top three major exporters of cheese on the world market (including the European Union and New Zealand), yet it’s the only one to have experienced a loss in market share between 2014 and 2015. This trend is likely to persist well into 2017 or until the dollar reverses course.

It is debatable whether Canada is violating the terms of Nafta, but ultra-filtered milk has wreaked havoc on U.S. farmer exports. Grassland Dairy Products Inc. in Greenwood, Wisconsin, lost Canadian business valued at about $100 million annually, and notified dozens of farmers that by May it wouldn't be able to take milk deliveries. Cayuga Milk Ingredients in Auburn, New York, has lost all of its Canadian exports, equal to 30 percent of total sales.

So what are government’s options? It could do nothing and blame the competition and/or the strength of the U.S. dollar and watch U.S. dairy farms disappear (which would be inadvisable as the industry is a vital and integral part of the economy). It could reconsider overturning Nafta (which the administration is now reconsidering as a viable tactic). The government could, like Canada, continue providing subsidies to the industry as it has done year after year for other industries such as energy. Washington could redirect funds away from a Mexico border wall toward saving a worthy and threatened industry. There are many poverty-stricken communities, both at home and abroad, that would welcome our excess inventories. Or we can continue to pressure Canada, our neighbor and friend, to reclassify 4M milk – this last choice, but the most obvious.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shelley Goldberg is an investment adviser and environmental sustainability consultant. She has worked as a commodities strategist for Brevan Howard Asset Management and Roubini Global Economics.

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