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BABCOCK INSTITUTE DISCUSSION PAPER No. 94-1

IMPLICATIONS OF THE NORTH AMERICAN FREE TRADE AGREEMENT FOR THE UPPER

MIDWESTERN DAIRY INDUSTRY

W.D. Dobson

The Babcock Institute for International Dairy Research and Development is a joint program of

University of Wisconsin-Madison College of Agricultural and Life Sciences University of Wisconsin-Madison School of Veterinary Medicine

University of Wisconsin Extension Cooperative Extension Division Funding for this study was provided by

CSRS USDA Special Grant 92-34266-7304

The views expressed in Babcock Institute Discussion Papers are those of the authors;

they do not necessarily represent those of the Institute, nor of the University

Babcock Institute, 240 Agriculture Hall, College of Agricultural and Life Sciences,

1450 Linden Drive, Madison WI 53706

© University of Wisconsin 1994

Table of Contents

Executive Sununary ........................................................................................................ 1 Part I: The Economic Environment for Dairy Exports to Mexico Under the NAFfA ...................................................................................................................... 1 NAFfA's Impact on Revenues of the Upper Midwestern Dairy Industry ................ 2 Part II: Profits for Upper Midwestern Dairy Firms from Exporting Dairy Products to Mexico Under the N AFf A. ................................................................... 2

IMPLICATIONS OF THE NAFfA FOR 1HE UPPER MIDWESTERN DAIRY INDUSTRY ..................................................................................................................... 4 Objectives ........................................................................................................................ 4 Economic Environment and Revenue Impacts of the NAFfA ...................................... .4

The Economic Environment for Dairy Exports to Mexico under the NAFf A ........ .4 I. Mexican Tariffs and Import Licenses for Dairy Products ................................. 6 II. Limited Consumer Purchasing Power in Mexico ............................................. 9 m. U.S. Firms' Experience (or lack thereof) In Serving Mexican

Customers ......................................................................................................... 10 IV. Superior Market Opportunities for U.S. Firms in the Domestic Market ........ 11 V. Transportation Costs ......................................................................................... 12 VI. Regional Product Mix ..................................................................................... 12 VII. Efforts by Mexico to Achieve Greater Self-Sufficiency in Milk

Production ........................................................................................................ 14 VIII. Experience with the USDA's DEIP Program ............................................... 16 IX. Competition from the EC, Canada, Uruguay, and New Zealand .................... 17 X. Competition from Firms Located in Mexico .................................................... 18

NAFf A's Impact on Sales and Revenues of the Upper Midwestern Dairy Industry ...................................................................................................................... 19

Will It Be Profitable for Upper Midwestern Firms to Expand Dairy Exports to Mexico Under the NAFfA? ............................................................................................ 22 References .. ..................................................................................................................... 26

Tables

Table 1. U.S. Exports of Dairy Products to Mexico, 1989-92 ................... ..................... 5 Table 2. Mexican Tariffs and Import Licensing Arrangements for Dairy Products

Prior to the NAFf A ....................................................................... ................... 7 Table 3. Top-Five U.S. Producing States for Milk, Nonfat Dry Milk, Cheese, and

Ice Cream, 1992. . ............................................................................................. 14 Table 4. Data on Exporters of Nonfat Dry Milk to Mexico Under the DEIP

Program, 1992-Mid 1993 ...... ........................................................................... 17 Table 5. Country of Origin for Mexico's Milk Powder and Butteroil Imports, 1989

and 1990 ........................................................................................................... 18 Table 6. Regional Effects of the N AFT A. ....................................................................... 20 Table 7. Exporting Practices of Selected Firms Selling Dairy Products in Mexico ....... 24

Figures

Figure 1. Tariff Levied by Mexico Under the NAFTA on U.S. Milk Powder Imports Exceeding 40,000 Metric Tons .......................................................... 9

Figure 2. Weekly Prices of Nonfat Dry Milk in the Central and Western Regions of the U.S., 1992 ........................................................ ..................................... 21

IMPLICATIONS OF THE NORTH AMERICAN FREE TRADE AGREEMENT

FOR THE UPPER MIDWESTERN DAIRY INDUSTRY

W.D. Dobson1

Executive Summary

Part I: The Economic Environment for Dairy Exports to Mexico Under the NAFT A.

• Mexican tariffs on dairy imports were already relatively low prior to passage of the North American Free Trade Agreement (NAFTA). Hence, tariff reductions associated with the NAFTA are likely to have limited impacts on U.S. exports of dairy products to Mexico. Forces other than the NAFTA will have a greater influence on Mexican dairy imports than the trade pact itself.

• The 40,000 metric tons of milk powder that will enter Mexico duty free under the NAFrA is about 5% less than the average of U.S. exports of milk powder to Mexico during 1989-91. If enforced, the 139% tariff for imports exceeding 40,000 tons will preclude U.S. firms from making large yearly milk powder exports like the 98,000 ton total recorded for 1989.

• CONASUPO (Compania Nacional de Subsistencias Populares) is the government, monopoly importer of milk powder for Mexico. Private companies and LICONSA (Leche Industrializada Conasupo), a government processor of imported milk powder, have complained that CONASUPO represents an unnecessary bureaucratic layer. If CONASUPO is stripped of its status as monopoly importer of milk powder, the premium for dairy exporters will shift from knowing how CONASUPO operates to learning to deal with private importers and LICONSA.

• About 30% of Mexico's 85 million people have the purchasing power to be commercial customers for dairy products.

• Consumption and imports of nonfat dry milk for use in producing "inferior goods" (reconstituted milk and packaged milk powder) will decline as incomes of Mexican consumers increase. Consumption of "normal goods" such as yogurt, aged cheeses, and ice cream, on the other hand, will increase as Mexican incomes increase. But, because of persistent poverty in Mexico, expect consumption of "inferior goods" and Mexican imports of nonfat dry milk to remain large for the foreseeable future.

• California firms are positioned to expand exports of milk powder to Mexico. Proximity advantages and their product mix position Texas firms to increase exports of fluid milk and ice cream to Mexico. Wisconsin and Minnesota firms are positioned to supply additional aged cheese, whey powder, lactose, and other differentiated dairy products to Mexico.

1 W.D. Dobson is Distinguished Professor, Department of Agricultural Economics, University of Wisconsin-Madison.

Implications of the North American Free Trade Agreement for the Upper Midwestern Dairy Industry

• Land O'Lakes, Vincent Commodities, Schreiber Cheese, Wilfran Ag, and Luxor of California have used the Dairy Export Incentive Program (DEIP) to export U.S. dairy products. But these fIrms have made only small sales to Mexico and other large customers for U.S. dairy exports. Subsidiaries of European Community (BC) based fums have been the dominant suppliers of large foreign customers.

• Firms hoping to expand dairy exports to Mexico will want to follow Mexico's progress toward achieving greater self suffIciency in milk production under the NAFTA. Likely scenarios suggest that Mexico will make limited progress toward self suffIciency in milk production and continue to import dairy products for the foreseeable future.

• Mexico is a large market for dairy exports that enjoys vigorous competition for its business. In some recent years, Mexico has been the world's largest importer of milk powder. U.S. firms exporting dairy products to Mexico will encounter vigorous competition from Nestle, the New Zealand Dairy Board, Uruguayan exporters, and EC fIrms.

NAFf A's Impact on Revenues of the Upper Midwestern Dairy Industry

• An interregional competition study shows that for a "best guess" Mexican import demand scenario the impact of the NAFT A on producer revenues would be small. For Wisconsin, the NAFT A-induced change in producer gross revenues would be only +0.1 %. This translates into about a $0.01 per hundredweight increase in producer milk prices.

• The USDA's estimates of the additional dairy export sales generated by the NAFT A ($63 million per year) translates into about a $0.04 per hundredweight increase in industry revenues. This increase would be shared by dairy farmers, processors, exporters and transportation fIrms.

• While expanded DEIP exports of milk powder to Mexico would come mostly from California and other West Coast locations, these exports would increase milk prices in other parts of the U.S.

Part II: Profits for Upper Midwestern Dairy Firms from Exporting Dairy Products to Mexico Under the NAFTA.

•

•

•

Whether it will be profItable for Upper Midwestern dairy fIrms to initiate or expand dairy exports to Mexico depends heavily on factors specifIc to individual finns. Domestic sales and sales to the USDA under the dairy price support program will remain attractive to many fIrms.

Upper Midwestern fIrms can extract useful information on exporting to Mexico from practices of Dean Foods Company, the Foremost Ingredients Unit of Wisconsin Dairies Cooperative, Baskin-Robbins, the New Zealand Dairy Board, and M.E. Franks.

Information on the Mexican market for dairy products is available from numerous sources, including the National Dairy Board (NDB), U.S. Small Business Administration, U.S. Export-Import Bank, and the USDA's Foreign Agricultural Service. The NDB has targeted Mexico as a promising market for U.S. dairy

Babcock Institute Discussion Paper No. 94-} 2


exports. As part of targeting, the NDB has generated studies on the Mexican market for dairy products.

• Upper Midwestern dairy fInns planning to export dairy products to Mexico will find numerous strategies available for expanding those sales, including joint ventures, indirect exporting, the Dairy Marketing Initiative, and the DEIP.

• Upper Midwestern dairy fInns may discover that small-scale or experimental exporting to Mexico is a useful part of a long-term strategy for overcoming early mover advantages gained by border state and foreign firms. This experience would be valuable for serving the Mexican market when barriers to exporting to that country become still smaller.

Babcock Institute Discussion Paper No. 94-1 3


IMPLICATIONS OF THE NAFTA FOR THE UPPER MIDWESTERN DAIRY

INDUSTRY

W.D. Dobson

The North American Free Trade Agreement (NAFfA) created a single market of 360 million people stretching from the Yukon in Northwestern Canada to the Yucatan Peninsula in Mexico. As is well known, the NAFfA faced numerous challenges before it was approved by the U.S. House of Representatives and Senate in November 1993. Swift approval of the pact followed in Mexico and Canada, permitting the agreement to become effective on January 1, 1994. The debate in the U.S. regarding the NAFfA indicated that the trade pact would affect the various sectors of the economy and regions of the country differently. However, the debate also revealed that impacts of the agreement on different sectors and regions were not well understood. This study provides information about impacts of the NAFfA on one sector and one region -- the Upper Midwestern dairy industry. These results should help those affected by the agreement to adjust effectively to it.

Objectives

Specific objectives of the study are to:

(1) Analyze how the economic environment existing when the NAFfA became effective will affect sales and revenues of Upper Midwestern dairy farmers and dairy marketing fIrms.

(2) Analyze whether it is likely to be profItable for Upper Midwestern dairy fIIIDS to expand dairy exports to Mexico and, if so, identify strategies the fIrms could use to effectively expand dairy exports to that country.

Much of the regional analysis will focus on the impact of the NAFf A on dairy farmers and dairy marketing fIIIDS in Wisconsin and Minnesota. Mexico is emphasized in the analysis since agricultural trade relationships between the U.S. and Canada were not affected by the NAFf A. The study reflects perspectives gained by the author from U.S. government reports, Mexican government reports, dairy trade publications, and interviews of offIcials of the U.S. and Mexican dairy industries.

PART I

ECONOMIC ENVIRONMENT AND REVENUE IMPACTS OF THE NAFT A

The Economic Environment for Dairy Exports to Mexico under the NAFT A

The analysis for Objective No. 1 identifIes factors in the economic environment that will affect U.S. dairy exports to Mexico under the NAFfA and, when feasible, provides implications for the dairy industry of the Upper Midwest. The section concludes with fIgures on the impact of the NAFTA on dairy product sales and revenues of the Upper Midwestern dairy industry.

The export fIgures in Table 1 show the amounts and values of U.S. dairy exports to Mexico during 1989-92. These can be considered base period export fIgures which will



be influenced by the NAFf A and many other developments. Mexico is obviously an important market for U.S. dairy exports, accounting for about 22% of the value of U.S. dairy exports in 1992.

Table 1. U.S. Exports of Dairy Products to Mexico, 1989·92.

% of U.S. Dairy Exports to World for

Product 1989 1990 1991 1992 1992

Nonfat D~ Milk Amount (mt) 98,392 4,429 23,122 26,014 30.5 Value ($1,000) 70,040 5,498 36,849 40,898 30.8

Cheese Amount (mt) 620 1,828 3,236 5,919 38.9 Value ($1,000) 1,358 4,482 7,994 15,397 31.2

EvaQorated and Condensed Milk Amount (mt) 11,633 1,394 1,042 1,876 21.3 Value ($1,000) 18,478 936 488 1,009 10.1

Butter and Anh~drous Milkfat Amount (mt) 6,605 5,304 7,157 10,955 13.2 Value ($1,000) 11,318 10,341 11,105 19,908 14.7

Whe~ (Fluid or Dried) Value ($1,000) 11,370 7,539 10,073 15,463 21.0

Other Dairy Products Value ($1,000) 92,547 30,743 54,633 67,539 20.8

All Dairy Products Value ($1,000) 205,110 59,539 121,143 160,215 22.1

Source: U.S.D.A., Foreign Agricultural Trade of the United States, various issues 1990--92.

Nonfat dry milk and cheese exports to Mexico in 1992 accounted for 30.8% and 31.2%, respectively, of the total dollar value of U.S. exports of these products in that year. U.S. nonfat dry milk exports to Mexico exhibited substantial variability in recent years. For example, U.S. export tonnages of nonfat dry milk in 1990 declined about 95% from the high levels reached in 1989. U.S. cheese exports to Mexico were relatively small but exhibited a strongly upward trajectory during 1989-92.

Included in the "Other Dairy Products" category in Table 1 are products such as fluid milk, yogurt and ice cream. U.S. exports of fluid milk and yogurt totaled 19,744 mt and 906 mt in 1989 [23]. As expected, the U.S. has accounted for almost all of the fluid milk exported to Mexico in recent years.

Before the NAFT A became effective exports of U.S. dairy products to Mexico were constrained by a number of forces, including those noted below:



I. Mexico's tariff and non-tariff barriers, II. Limited purchasing power of Mexican consumers,

ill. Lack of experience on the part of U.S. firms in serving Mexican importers and consumers,

IV Superior market opportunities for U.S. fIrms in the domestic market, V. Transportation costs,

VI. A product mix in parts of the V.S. that fails to match Mexico's domestic consumption patterns,

VII. Efforts by Mexico to achieve greater self sufficiency in milk production, Vill. Limited experience of U.S. fIrms with the USDA's Dairy Export Incentive

Program, IX. Competition faced by V.S. firms from dairy exporters in the European

Community (EC), New Zealand, Uruguay, and Canada; and x. Competition faced by U.S. firms from ftnns located in Mexico.

The NAFfA will directly reduce only the tariff and certain non-tariff barriers to expanded dairy exports to Mexico. Hence, U.S. dairy exports to Mexico will still be constrained by a host of forces under the NAFf A. However, implementation of the treaty signals a further opening of the Mexican market, creating an environment which could reduce other impediments to U.S. dairy exports to Mexico.

Certain factors affecting the economic environment for U.S. dairy exports to Mexico have broadly similar effects across much of the U.S. dairy industry. Others have distinct regional impacts. For example, regional factors operate to place the Midwestern dairy industry at a disadvantage to competitors in Texas and California with respect to transportation costs, product mix, and knowledge of the Mexican consumer. The impact of the items listed above affecting U.S. exports of dairy products to Mexico are considered in turn, emphasizing those that have important regional effects.

I. Mexican Tariffs and Import Licenses for Dairy Products. Prior to the NAFTA, the tariffs and import licensing arrangements for dairy products

described in Table 2 were used by the Mexican government to protect the domestic industry, raise revenues, and achieve other policy objectives. These mechanisms limited dairy imports and affected most U.S. exporters of dairy products similarly. As indicated in the table, Mexican tariffs on dairy imports were already relatively small prior to passage of the NAFf A, reflecting tariff reductions Mexico made after joining the General Agreement on Tariffs and Trade (GATT) in 1986. Thus, tariff reductions and elimination of import licensing under the NAFf A may have limited impacts on imports of dairy products.



Table 2. Mexican Tariffs and Import Licensing Arrangements for Dairy Products Prior to the NAFT A.

Product License Tariff

Nonfat Dry Milk Yes 0% Cheese Yes 20 Ice Cream No 20 Yogurt No 20 Fluid Milk No 10 Evaporated Milk Yes 10 Condensed Milk No 15 Whey No 10 Butter No 20 Butteroil No 0 Lactose No 10

Source: National Dairy Board, "Mexican Import Documentation Requirements for Dairy Products," July 15, 1992.

From Mexico's standpoint, the most important tariff and licensing arrangements relate to nonfat dry milk, a major dairy import item for Mexico. At times in recent years, Mexico has been the world's largest importer of nonfat dry milk, accounting for about one-quaner of world imports of this product in both 1989 and 1990 [28].

The licensing requirement and zero tariff for nonfat dry milk conceal complexities involved in exporting this product to Mexico. Mexico imports milk powder through a government monopoly called CONASUPO (Compania Nacional de Subsistencias Populares) which controls importing for the product. CONASUPO in tum supplies another governmental organization named LICONSA (Leche Industurializada Conasupo) with milk powder which the latter uses to produce reconstituted milk and packaged milk powder sold at subsidized prices to low income people in Mexico. CONASUPO also conducts milk powder auctions where private fInns purchase imported milk powder for use in producing dairy products sold through commercial channels in Mexico.

It is not known how long CONASUPO will survive as monopoly importer. Officials of private dairy firms in Mexico and LICONSA offIcials have complained that CONASUPO represents an unnecessary bureaucratic layer and has blundered in its importing practices. On the latter point, a Nestle offIcial pointed out that in 1990 CONASUPO imported so much milk powder that some of it went out of condition before it was used. A LICONSA official said that CONASUPO at times was unable to arrange for delivery of imported milk powder on schedule, forcing him to close processing plants for up to several days. The government of Mexico has considered privatizing milk powder importing. If private fIrms and LICONSA are permitted to import for their own account, this will change the knowledge required to export milk powder to Mexico. For exporters, the premium will shift from knowing how CONASUPO operates to learning to deal with private importers and LICONSA.

Control of milk powder imports is a primary mechanism used to protect Mexico's domestic dairy industry. In ad,dition to the heavy use of milk powder for producing reconstituted milk, this product is used as an ingredient for making ice cream, cheese, and



other dairy products. Unlimited imports of this versatile product at world prices would reduce domestic milk production sharply in Mexico.

How does the NAFf A change the tariffs and import licenses? When the NAFf A went into effect, Mexico converted its import licensing arrangements for milk: powder into a tariff rate quota (TRQ) that operates as follows:

• The IRQ will remain effective during a 15-year transition period. • Duty free access to the Mexican market will be assured for an aggregate of 40,000

metric tons (mt) of U.S. nonfat dry milk: and whole milk powder. The amount of U.S. milk powder that enters Mexico duty free will grow at a 3% annual compounded rate over the 15-year transition period.

• U.S. exports of milk: powder in excess of 40,000 mt initially will be subject to a 139% tariff. During the fIrst six years of the trade agreement, 24% of the tariff will be eliminated. The remainder of the tariff will be phased out over the remainder of the 15-year transition period. The tariff reductions on milk: powder will be carried out in equal 4% installments during the first six years and on a straight line basis during the remaining years of the NAFf A (Figure 1).

For cheese, Mexico will change the tariffs and import licensing arrangements as follows:

• Under the NAFfA, Mexico will convert its import licensing arrangement for cheese to tariffs.

• Mexican imports of cheese currently subject to import licensing will be assessed a 20% tariff, which will be reduced to zero during a 10-year transition period.

• An exception applies for fresh cheeses, which will be subject to a 40% tariff that will be reduced to zero over a lO-year period.

Tariffs on most other dairy items will be phased out over a to-year period.

The high tariff for over-quota imports of milk: powder, the I5-year adjustment period for milk powder, and 40% tariff for fresh cheeses are structured to give Mexico's dairy industry time to become competitive producers of these items. The USDA claims that the 139% tariff on milk powder represents "tariffication" of Mexico's milk: import licenses for the product. However, using Mexican dairy statistics, the author found it impossible to reproduce figures showing that tariffication of import licensing and related non-tariff barriers would produce a tariff as high as 139%. Thus, the levy on over quota imports might be interpreted as a tariff which gives Mexico's dairy industry a reasonable amount of time to adjust to strong competition from imported milk: powder.

The 40,000 mt of milk: powder that will enter Mexico duty free under the NAFfA is about 5% less than the average of U.S. exports of milk powder to Mexico during 1989-91. If enforced, the high 139% tariff for imports exceeding 40,000 mt precludes U.S. firms from making powdered milk: exports to Mexico in any year as large as the 98,000 ton total recorded for 1989.

USDA's preliminary estimates indicate that U.S. milk powder exports to Mexico would increase by about 20,000 mt per year by the end of the 15-year transition period, adding about $36 million to annual export sales [27]. The comparable NAFfA-induced increase for dairy products other than milk powder was estimated by the USDA to be about $27 million per year [27]. The $63 million is equivalent to about 0.32% of the $19.7 billion of U.S. farm receipts from sales of milk: in 1992. Presumably dairy farmers, processors, exporting firms, transportation firms, and others would share the $63 million in increased revenues from the larger dairy exports.



Figure 1. Tariff Levied by Mexico Under the NAFT A on U.S. Milk Powder Imports Exceeding 40,000 Metric Tons

140

120

-~ 100 0 '-" --.~ ctS

80 l-E <l> .... 0 60 ctS > "'0 « 40

20

0 1994 1999 2008

Year

Source: U.S.D.A., Office of Economics, "Preliminary Analysis of the NAFTA on U.S. Agricultural Commodities," September 1992.

Even the modest increases in U.S. dairy exports to Mexico just mentioned will not happen automatically. Private fIrms must secure the larger exports. The following sections analyze the incentives and disincentives that exporters of U.S. dairy products -especially those located in different regions of the country -- will face as they seek to expand dairy exports to Mexico.

IL Limited Consumer Purchasing Power in Mexico. Opportunities for expanding exports of U.S. dairy products will be influenced by

changes in the incomes of Mexican consumers. In particular, consumption of nonfat dry milk, part of which is used to produce what economists call "inferior goods" (reconstituted milk, packaged milk powder, etc.) will decline as incomes of Mexican consumers increase. Consumption of "normal goods" such as yogurt, aged cheeses, and ice cream can be expected to increase as Mexican incomes increase.

Consumer income measured by per capita gross national product in Mexico during 1990-91 averaged about U.S. $2,800 which was 12% to 13% of the comparable fIgure for the U.S. [3,30]. This fIgure is influenced by unemployment and underemployment. Mexico's unemployment in recent years has been about 18% of the labor force. Up to an additional 40% of Mexico's workers are underemployed.

The NAFT A is expected to attract additional investment to Mexico, make Mexican industries more competitive, and produce other changes that boost the incomes of Mexican people. There is a consensus that the NAFf A will increase Mexico's GNP by



0.5% per year [24J. Mexico's real GNP has grown by an average of 2.5% to 4.5% per year during 1988-92 [13]. However, during parts of 1993 Mexico was in or near recession as growth fell below 1 %. The Salinas government implemented a stimulus package and passage of the NAFfA will help to pull Mexico out of recession. But even if growth increases at a sustained rate of 5.0% per year, it still would require about 14 years for Mexico's GNP to double. After taking into account population growth (about 2% per year) and income figures, it could require a generation to push per capita incomes in Mexico to levels now existing in Spain, a European country where consumer incomes are below the EC average.

The uncertainties regarding Mexico's economic development make it difficult to assess how rapidly Mexican incomes will increase. However, it is likely that a large segment of the Mexican popUlation will have low incomes for an extended period. In part this is because land reform and the industrialization of Mexico's agricultural sector will push more of Mexico's rural population (29% of the total) into the cities where their employment prospects are dim [18].

A Nestle official in Mexico estimated that of the 85 million people in Mexico, 25 to 27 million (about 30%) had the purchasing power to be counted as commercial customers. While Mexico does not exhibit the mass market characteristics of the U.S. or Canada, the country does have sizable middle and upper income groups. Merchandisers of upmarket dairy items can target these groups.

The National Dairy Board and Nestle officials indicate that consumer demand is growing strongly for yogurt, ice cream, and certain cheeses. Growth of consumer incomes in Mexico should further expand the demand for these items. But because poverty will persist, expect consumption of "inferior goods" and imports of nonfat dry milk by Mexico to remain large for the foreseeable future.

m. U.S. Firms' Experience (or Jack thereof) In Serving Mexican Customers. Dairy companies in Texas, California, Arizona, and New Mexico have an edge over

firms in the Upper Midwest on this point. Texas fluid milk processors, for example, have gained experience selling fluid milk products in Northern Mexico and in other parts of Mexico -- especially in Mexico City and other cities where tourism is an important business. At least nine Texas fluid milk processors and distributors were selling dairy products Mexico in 1991 [23].

Dean Foods Company is among the most prominent of the U.S. finDS selling dairy products in Mexico. Dean Foods has sold fluid milk products in Mexico from its Texas and New Mexico plants for about five years [4]. The firm's customers include the huge Wal-Mart store in Mexico City. Dean's sales of milk and ice cream in Mexico total about $10 million per year [26].

Hygeia Dairy of Harlingen, Texas recently began distributing dairy products in Mexico [8]. Company officials report that experience gained while serving its domestic customers, 75% of whom are Hispanic, prepared them for entering the Mexican market.

Presumably firms in border states that have developed cheeses and other dairy products for U.S. Hispanics have acquired experience that will help them expand exports of dairy products to Mexico. California finDS are prominent developers of such products. These finDS have been aided by the California Milk Advisory Board which developed advertising messages focused on Hispanics [17]. However, production of cheeses and other dairy products for the U.S. Hispanic market and Mexican market is not the exclusive province of border state firms, as noted below:

Baocock Institute Discussion Paper No. 94-1 10


• Specialty Cheese Company of Lowell, Wisconsin has developed a 13-variety line of Mexican cheeses,

• Land O'Lakes has developed a marketing program for Lake to Lake cheese targeted at Southern California Hispanics,

• Wisconsin Dairies Cooperative, through its Foremost Ingredients unit, sells pharmaceutical lactose and dried whey products to Mexican customers,

• Old World Cheese in Benton Harbor, Michigan has developed Spanish cheeses and queso blanco (white cheeses) for Mexican Hispanics, and

• Wells Dairy of LeMars Iowa has established ice cream distribution in Guadalajara, Monterrey, Mexico City, Chihuahua, Leon and Torreon.

As discussed later, Upper Midwestern dairy companies have not used the USDA's Dairy Export Incentive Program (DEIP) extensively to export U.S. dairy products to Mexico. In 1992 and the ftrst half of 1993 almost all DEIP exports of U.S. dairy products to Mexico were made by U.S. subsidiaries ofEC ftrms.

The limited experience of Midwestern dairy ftrms in serving the Mexican market does not mean that these ftrms have employed faulty strategies. Some have chosen to emphasize exports of dairy products to Japan and elsewhere in the Pacific Rim. However, if Upper Midwestern fIrms decide to expand sales in the Mexican market, they will have to overcome the early mover advantages gained by ftrms in the border states, EC fIrms, Uruguayan fIrms, and the New Zealand Dairy Board.

IV. Superior Market Opportunities for U.S. Firms in the Domestic Market. The size of the market, purchasing power of a huge group of affluent consumers,

transparency of the laws and health regulations governing dairy product sales, manageable accounts receivable, good transportation system, and other factors make the U.S. market desirable. In addition, the USDA's dairy price support program provides an outlet for surplus butter, cheese, and nonfat dry milk at prices generally above those available in the world market. Import quotas, which allow imports equal to only about 2% of U.S. production also have protected the domestic industry .. In 1991-92, the import quotas and dairy price support program kept U.S. prices for nonfat dry milk, butter and cheese 35% to 70% higher than world prices for these items [9] .

Therefore, it is not surprising that many U.S. dairy ftrms have placed little emphasis on exporting. However, conditions are changing in ways that may make exporting more attractive for U.S. dairy companies. Dairy price supports have declined sharply. For example, farm price supports for milk under the 1990 Farm Bill are 25% lower (50% lower in real terms) than peak levels recorded in 1981. Secondly, if the GATT agreement reached late in 1993 eventually becomes effective, the "minimum access" provisions will make the U.S. moderately more open to imports of dairy products. Third, foreign direct investment from the EC and New Zealand has created increased competition for raw milk and ftnished product sales in the domestic market. Companies affiliated with the New Zealand Dairy Board made sales of about $0.5 billion in the U.S. during 1989-90 [10]. EC farmers and dairy processors (especially those from Ireland), who were prevented from expanding output by EC milk production quotas, have made direct investments in the U.S. dairy industry. These developments have made the U.S. an integral part of a competitive global market for dairy products. Exporting may become a more widely used competitive strategy in such an environment.

Many dairy products produced in the U.S. are sold in mature, slowly growing markets. Much growth in demand for commodity-type dairy products stems from population growth. The U.S. population growth rate was only about 1 % per year during the 1980s and is forecast to grow still more slowly early in the next century. American-



type cheese sales, in particular, appear to have been affected by these developments. After exhibiting a sharply upward trajectory during the 1980s, American cheese sales seem now to be more nearly flat [15].

These developments are likely to give U.S. firms incentives to develop new dairy products and seek new dairy markets, including export markets. Because of proximity, the Mexican market will receive attention from new and established exporters. Several avenues are available for increasing dairy exports, including the DEIP program, joint ventures between U.S. and Mexican companies, and sale of specialized, differentiated products without export subsidies in the Mexican market.

V. Transportation Costs. While U.S. dairy products can be exported to Mexico by truck rather than ocean

freight, the costs for shipping products to Mexico exceed those for serving equally distant locations in the domestic market. Roads are generally poorer in Mexico. Transportation regulations also increase costs. Prior to the NAFf A, trailer loads of product hauled to the Mexican border apparently had to be off-loaded onto Mexican trucks for transport to the destination. Alternatively, a Mexican tractor could be used to pull the U.S. trailer to the destination. Either option increases transportation and handling costs. Such costincreasing regulations presumably will be eliminated within a few years as trade between the countries increases under the NAFfA.

The effects of transportation costs need little additional discussion since the effects are apparent and related to items discussed elsewhere. As a source of advantage for serving the Mexican market, transportation costs are most important for bulky fluid items. Because of exporting experience and proximity advantages that reduce shipping costs, processors located in Texas, California, New Mexico, and Arizona possess advantages for exporting packaged fluid milk products to Mexico. Experience in the U.S. and elsewhere suggests that their advantage is smaller for yogurt, ice cream, cream cheese, and certain other soft dairy products. For example, certain large dairy firms in both the U.S. and Australia process these items at central locations and distribute them over wide geographic areas, suggesting that transportation costs are a less important impediment to serving distant markets for these items than for fluid milk. Transportation costs also do little to impede exports of pharmaceutical lactose and other high-valued, differentiated dairy products.

Transportation costs assume some importance for milk powder, butter, and commodity cheeses. Texas firms possess transportation cost advantages for supplying the Mexican market with these items. But, as pointed out later, they are not major producers of these items. While California finns are major processors of these products, Northern California locations are no closer to parts of Central Mexico than firms located in Southern Wisconsin and Southern Minnesota. Hence, the transportation cost advantage of Californians for supplying Mexico with these products should not be overestimated.

VI. Regional Product Mix. A U.S. region's competitiveness for supplying the Mexican market will be shaped

partly by the region's production mix. At the risk of noting the obvious, if processors in a state are leading producers of an item that Mexico imports, they are likely to develop the capabilities needed to be important and dependable suppliers of the item to Mexico. Innovations in production and marketing also tend to occur in regions where milk production is increasing rapidly.



As noted earlier, Mexico imports nonfat dry milk, cheese, and ice cream from the U.S. Figures for 1992 for the top-5 producing states of these products and for milk appear in Table 3.

Wisconsin and California were the leading milk producing states 1992. California increased its share of U.S. milk production from 10.6% to 14.6% of the U.S. total from 1980 to 1992. Moreover, beginning in August 1993, California's milk production exceeded that for Wisconsin. Expansion of milk production in California has been accompanied by construction of large, new milk processing plants. Also, Luxor of California emerged as one of the few U.S. fIrms to export substantial amounts of dairy products under the DEIP in 1992.

Dairy firms in California and Washington accounted for nearly 58% of U.S. production of nonfat dry milk in 1992. California's share of production has increased sharply in recent years, rising from 21 % of the U.S. total in 1980 to the 41 % fIgure for 1992. Darigold, a major cooperative in Washington, has recently developed additional milk powder processing capacity, which will add to that state's total in future years. Processors in Wisconsin and other states account for much smaller percentages of national production of milk powder.

Production shares for cheese reveal a different pattern. Wisconsin processors accounted for 32% of total U.S. cheese production in 1992. While this fIgure is lower than the 37% production share recorded for Wisconsin in 1980, it is still the largest percentage for any state by a wide margin. California and Minnesota fIrms held 12% and 10% production shares, respectively, in 1992. California's share of national cheese production increased from 5% of the U.S. total in 1980 to its present 12%.

California fIrms ranked No.1 in ice cream production in 1992. Unlike the situation for nonfat dry milk and cheese, production of ice cream is not concentrated in the top-5 states. Only a little more than a third of U.S. ice cream is produced in these 5 states. However, California and Texas fIrms are major ice cream producers which, given their proximity advantages, makes them potentially important suppliers of this product to Mexico.

To the extent that production mix influences exports, California seems positioned to be a major exporter of milk powder to Mexico. Texas seems positioned to supply ice cream and fluid milk to Mexico. Production patterns in Wisconsin and Minnesota suggest that cheese and whey by-product exports might originate in those states.

These fIgures give only general indications of the location of fInns which might expand dairy exports to Mexico. Actual exporting patterns will reflect strategic decisions of firms. For example, whether Washington processors will export milk powder to Mexico is unclear. Darigold Cooperative of Washington was an important supplier of nonfat dry milk to Mexico during 1988-89 when tight supplies pushed world nonfat dry milk prices above the U.S. support prices. Presumably Darigold could repeat such exports if world nonfat dry milk prices again rose above U.S. support prices. But Darigold also might fInd PacifIc markets attractive if such price relationships reappear since the Cooperative's CEO has experience in exporting to Far-Eastern markets [16].


· Implications of the North American Free Trade Agreement for the Upper Midwestern Dairy Industry

Table 3. Top-Five U.S. Producing States for Milk, Nonfat Dry Milk, Cheese, and Ice Cream, 1992.

Product and State

Milk (Mil. lbs.) Wisconsin California New York Pennsylvania Minnesota Total Top-5 States U.S. Total

Nonfat Dry Milk (1,000 lbs.) California Washington New York Wisconsin Michigan Total Top 5 States U.S. Total

Cheese (1,000 lbs.): Wisconsin California Minnesota New York Pennsylvania Total Top 5 States U.S. Total

Ice Cream (1,000 gallons) California Pennsylvania Texas Ohio Minnesota Total Top 5 States U.S. Total

Production

24,103 22,084 11,582 10,364 9,854

77,987 151,747

359,872 142,102 28,153 22,406 17,742

570,275 872,123

2,052,913 789,379 662,245 529,612 312,670

4,346,819 6,488,291

113,713 65,118 53,052 43,034 41,917

316,834 821,738

% of U.S.Total

15.9% 14.6 7.6 6.8 6.5

51.4 100.0

41.3% 16.3 3.2 2.6 2.0

65.4 100.00

31.6% 12.2 10.2 8.2 4.8

67.0 100.0

13.8% 7.9 6.5 5.2 5.1

38.6 100.0

Sources: U.S. Department of Agriculture, Daily Products Annual Summary, 1992 and Milk Production, Disposition, and Income, Summaries for 1980 and 1992.

VU. Efforts by Mexico to Achieve Greater Self-Sufficiency in Milk Production. Expansion of U.S. dairy product exports to Mexico will be influenced by how much

Mexico's domestic milk production increases. Mexican government officials interviewed spoke of efforts to increase the degree of self-sufficiency in milk production -- partly to shield the economy from possible sharply higher prices for imported milk powder. In the 1980s and to a lesser extent in the early 1990s, the Mexican government provided credit, insurance, feed subsidies and technical assistance to dairy farmers. But producer subsidy equivalent figures reported by Hallberg, Cranney, Smith and VaIdes suggest that price supports and border measures used by the Mexican government during 1985-90 swamped these subsidies and produced an implicit tax on Mexico's milk producers [14].



Recognizing the implicit tax, Mexican dairy industry officials interviewed suggested that government talk of providing incentives for greater self sufficiency in milk production represented giving Jip service to producers who feared expanded dairy imports.

Milk production per cow in Mexico averages only about one-quarter as large as the average for the U.S. While this seems to identify a primitive dairy producing sector, this is an oversimplification. Mexico has three main types of dairy farming operations [1,14]:

• The confined system is similar to large-scale dairy farms in California. Modern technologies including Bovine Somatotropin are used on some of these farms which have an average size of about 230 cows. However, because of low labor costs, hand milking is still common on many of these farms. In Northern Mexico, over 50% of these farmers still employed hand milking. On many of the farms, milk cooling facilities also are not as modern as those found in the U.S. Replacement stock for these farms are often obtained from the U.S. or Canada. Estimates of milk production costs for the early 1990s for confined system farms range from $13.36 to $15.62 per hundredweight. The lower of these costs compares favorably with milk production costs in the Southern Plains of the U.S.

• The semi-confined. pastoral system of dairy farming is found throughout Mexico's central and northern regions. Cattle on these farms consist mainly of Zebu and Holstein or Zebu and Brown Swiss crosses. Technologies on these farms, which average about 40 cows, are less advanced than on the confined systems. A Nestle official suggested that these farms must produce more milk if Mexico's dairy industry to progress toward self-sufficiency.

• Dual purpose systems, where technologies are least advanced, produce milk as a by-product of beef production. These farms which have mostly Zebu cattle are found primarily in the Mexican tropics.

In the early 1990s, the percentage of cows and milk represented by the three type of dairy farming systems was approximately as follows [1,14]:

System

Confined Semi-Confined, Pastoral Dual-Purpose

Percentage of Cows

14% 23 63

Percentage of Milk

55% 15 30

It is difficult to forecast how much Mexico's domestic milk production will expand during the next few years. Milk production figures used by Mexico's policy makers -perhaps the most reliable figures available -- show that Mexico's milk production declined during the late 1980s before increasing to a level 6% above the 1981 level during 1991 and 1992. The recent increase in milk production reflects, in part, favorable weather. Whether the recent increase will continue depends partly on rainfall and upon the success of efforts of private finns to increase milk production in the Mexican tropics. Nestle and other Mexican milk processors have attempted to increase milk production and sales in the Mexican tropics by providing milk collection and cooling facilities for use by farmers. The success of these efforts will be affected by the price of milk relative to beef prices. High milk prices relative to beef prices will cause farmers to market the milk rather than let it be consumed by beef calves.

Balxock InstittJte Discussion Paper No. 94-1 15


An analysis of Mexican milk production costs, which is being carried out as part of another study financed through the Babcock Institute, will shed more light on whether Mexico is likely to become substantially more self sufficient in milk: production. Other studies and comments by a business official revealed the following about this question:

StudyIComment

Hallberg, Cranney, Smith and Valdes [14]:

Dobson tl.al. [11]:

Cox [5]:

Corbett of Dean Foods [4]:

Result

Milk consumption in Mexico is likely to to increase more rapidly than milk production.

Only under a high milk production, low consumer demand scenario is Mexico likely to become more nearly self-sufficient in milk production by the end of the 1990s.

Under a "best guess" scenario characterized by medium growth in Mexican milk production (7 % per year in the Southeast and 5% per year growth in the rest.of Mexico) and high consumption growth, U.S-Mexico dairy trade increases by 4% over a five-year period.

Mexico produces only 50% of its milk supply. Expect Mexican demand for U.S. dairy products to continue for at least 20 years.

These findings suggest that scenarios depicting limited progress toward greater selfsufficiency in milk production in Mexico are likely to materialize. Indeed, impediments to increased milk production appear to be substantial in Mexico; much of the country's land appears better suited to producing vegetables, fruit, coffee, and beef cattle rather than milk.

The TRQ arrangement for milk powder imports (with a 139% tariff for over quota imports), the 40% tariff on fresh cheeses, and the relatively long adjustment periods before the tariffs go to zero for both commodities will give Mexico a chance to find out whether the country can become more nearly self-sufficient in milk production. Firms seeking to expand exports to Mexico will find it advantageous to follow Mexico's progress in achieving greater milk production during the adjustment periods under the NAFTA for tariffs on dairy imports.

Vill. Experience with the USDA's DEIP Program. The DEIP is presently the export mechanism through which bulk dairy exports are

made to Mexico. Prior to 1992, exports of bulk U.S. dairy exports were government-togovernment sales made under direct sales mandates and other subsidy programs. In 1992, Mexico became eligible for DEIP export subsidies and private firms began exporting dairy products to Mexico aided by export subsidies provided by the program.

Finns exporting nonfat dry milk to Mexico, country location of parent company for the exporters, amount of product exported, and subsidy obtained appear in Table 4. These figures reveal a familiar pattern that characterizes exports of U.S. dairy products to all countries under the DEIP. U.S. dairy products are being exported under the DEIP but the dominant exporters and primary recipients of DEIP export subsidies are U.S. subsidiaries of EC-based firms.



Table 4. Data on Exporters of Nonfat Dry Milk to Mexico Under the DEIP Program, 1992-Mid 1993.

Exporter

M.E. Franks Hoogwegt Union Commerciale Irish Dairy Board Galaxy Trade Wilfran Ag. Dairy Trade

Totals

Location of Parent Company

Belgium Netherlands France Ireland Unknown U.S. Unknown

Subsidy permt

$783 790 805 792 774 793 774

Amount Sold (mt)

31,288 10,338 7,087 4,750 2,787 2,750 1,000

60,000

%of Total

52.1% 17.2 11.8 7.9 4.7 4.6 1.7

100.0

Source: U.S.D.A. Foreign Agriculnrral Service, "CY-1992 Bid Acceptance Summary," January 25,1993 and "CY-1993 (to July 7,1993) Bid Acceptance Summary," July 12, 1993.

Of course, the U.S. government realizes budget savings whether the sales are made by EC fIrms or U.S. fIrms. It costs the government only about one-third as much to off-load nonfat dry milk onto foreign markets with the aid of export subsidies as to purchase the product under the price support program. And domestic milk producers obtain higher prices from the tighter domestic supply-demand balance produced by the exports. But, if EC-based fIrms remain the main exporters under the DEIP, U.S. fIrms will not gain the exporting experience needed to become competitive exporters for Mexico or other foreign markets. Indeed, if the current pattern of exports under the program continues and the DEIP program ends when it comes up for renewal under the 1995 Farm Bill, U.S. firms will have gained little from the DEIP which helps them become experienced, commercial exporters of dairy products.

It is no surprise that EC exporters are successful bidders for the DEIP subsidies. The EC-based exporters have experienced personnel and market connections that enable them to underbid U.S. fIrms for export subsidies which the USDA awards to qualifIed low bidders. This may indicate that the USDA gives too much attention to accepting low bids and too little attention to market development [9).

All is not gloomy about participation by U.S. fIrms in the DEIP. U.S. fIrms including Land O'Lakes, Vincent Commodities, Schreiber Cheese, Wilfran Ag, Luxor of California and others have made DEIP sales during 1992-93. But,these sales typically have been in smaller amounts to countries that are not large customers for U.S. dairy products. Their success in selling to Mexico, Algeria and other major markets has been limited.

IX. Competition from the EC, Canada, Uruguay, and New Zealand. Mexico is a large market for dairy exports which enjoys vigorous competition for its

business. The EC accounts for about 50% of world exports of dairy products and, as indicated in Tables 4 and 5, is a major player in the Mexican market. Most EC dairy exports are subsidized exports. Canada is a minor exporter of dairy products and its exports are heavily subsidized. New Zealand's Dairy Board is world's largest nonsubsidizing exporter, accounting at times for up to one-quarter of world dairy exports. Uruguayan fIrms are frequently leading exporters of cheese to Mexico [1). These sales are made without subsidy.



Table 5. Country of Origin for Mexico's Milk Powder and Butteroil Imports, 1989 and 1990.a

Country of Milk Powder % of Total Butteroil % of Total Origin (mt)

United States 21,092 7.3 12,525 54.9 Canada 6,215 2.2 England 16,668 5.8 France 38,692 13.5 3,377 14.8 Ireland 71,897 25.0 1,579 6.9 Netherlands 1,428 6.2 New Zealand 75,092 26.1 3,210 14.1 Germany 18,423 6.4 Others 39.377 13.7 ..-.l.U ~ Total 287,456 100.0 22,832 100.0

a Milk powder imports are for 1990 while the Butteroil imports are for 1989.

Sources: U.S.D.A., Agricultural Affairs Offices, Mexico City, Dairy Annual Report 1990, and Dairy Semi-Annual Rewrt 1991.

The figures in Table 5 relating to U.S. milk powder and butteroil exports to Mexico differ from those in Table 1. It is unclear why the discrepancy exists. But, since the data in the two tables were compiled by different organizations, the U.S. exports of milk powder and butteroil may have been assigned to different years by the compiling organizations.

Finns in the EC, Canada, New Zealand, and Uruguay probably will continue to be important suppliers for Mexico and strong competitors for U.S. firms under the NAFfA. Nothing in the trade agreement prevents Mexico from buying subsidized exports of dairy products from the EC and Canada. The New Zealand Dairy Board also has experienced traders operating in Mexico who will likely compete vigorously for sales.

X. Competition from Firms Located in Mexico. U.S. dairy companies entering the Mexican market will encounter competition from

several sources. Mexico's main dairy processing and marketing organizations can be grouped as follows:

• Multinationals. Finns in this category include Nestle, Kraft, Dannon, and BaskinRobbins. Nestle, a strong and politically well-connected firm, operates processing plants throughout Mexico where the firm processes reconstituted milk, filled milk, ice cream, and other dairy products. Nestle is regarded by domestic processors as a powerful producer of high quality products. Nestle is likely to exert strong influence on Mexico's domestic dairy policy and implementation of trade agreements affecting Mexico's dairy industry.

Kraft and Dannon serve upmarket segments of the consumer market for cheeses and yogurt, respectively. Baskin-Robbins has entered into a joint venture with a Mexican firm to open ice cream shops in Mexico City, Monterrey, Guadalajara, Acupulco, and Cuemavaca [7].

Balx:ock Institute Discussion Paper No. 94-1 18


• Domestic Fluid Milk Processors. Major domestic fluid milk processors include Grupo Alpura, Grupo LALA, Guilsa, and Boreal [14]. Boreal was formerly a government cooperative that has been privatized. In many respects, plants operated by these firms resemble small and medium-sized plants in the U.S.

Domestic fluid milk processors expressed concern about competition from the U.S. processors, the government feed grain subsidies received by U.S. dairy farmers, and price supports received by the U.S. dairy industry. A pasteurizers union representative called for harmonizing sanitary regulations between the U.S. and Mexico. He emphasized that U.S. firms, like Mexican processors, should be required to place the processing date on packages of fluid milk sold in Mexico. In general, the strong concerns expressed about U.S. competition suggest that Mexican processors believe U.S. processors will make important inroads into Mexican fluid milk markets.

• LICONSA. This government organization was a major processor of reconstituted milk, packaged milk powder, UHT milk and pasteurized milk in the 1980s and 1990. According to Hallberg, Cranney, Smith and Valdes, in 1990 LICONSA operated 16 manufacturing plants with a labor force of over 7,000 workers and also operated 1400 retail stores distributing 5 million liters of reconstituted milk daily and other food products to low income people [14]. After 1990, LICONSA began divesting itself of milk processing plants and retail stores. The functions previously handled by its plants and retail stores are being assumed partly by private finns. Its new focus is on providing subsidies needed to supply milk to about 11 million children from low income families by 1994. LICONSA is likely to influence the amounts and tenns under which milk powder is imported by Mexico in the future.

• Non-Commercial Processors. Large percentages of the dairy products consumed in Mexico do not go through commercial market channels. Hallberg, Cranney, Smith and Valdes report that 30% to 50% of Mexican milk is consumed as unpasteurized, unchilled fresh fluid milk or processed into cheese by dairy farmers and sold directly to consumers [14]. More than 2500 plants existed in 1988 from which cheese, cream and butter were produced and distributed. Many were small, non-commercial plants from which dairy products were sold by vendors. One small processor said that tuberculosis, brucellosis, and salmonella problems exist regarding cheeses produced and sold by some small operators. These problems doubtless create quality image problems for multinationals, commercial fluid milk processors, and importers seeking to expand sales of dairy products in Mexico.

Mexico's dairy markets will undoubtedly take on more characteristics of commercial markets as consumer incomes increase. However, the market segment devoted to serving low income people will remain large and important.

NAFfA's Impact on Sales and Revenues of the Upper Midwestern Dairy Industry

Available information suggests that the impact of the NAFfA on sales and revenues of dairy farmers and milk processors in the Upper Midwest would be small. Results obtained by Cox and USDA information were used to quantify those effects.

Cox employed a 14-sector interregional competition model to examine the regional effects of the NAFf A, modeling the agreement as an exogenous shock to the U.S. dairy sector. Selected regional impacts of the NAFf A on gross producer revenues for the "best



guess" Mexican import demand scenario (medium production growth and high consumption growth for Mexico) are shown in Table 6.

Table 6. Regional Effects of the NAFT A.

Region and U.S.

Wisconsin West NC (MN,ND and SD) California West SC (TX,NM and OK) U.S.

Farm-Leyel Total Revenue ($ Mil.) 1989-92 Average NAFfA Scenario

$ 3,344 1,762 2,946 1,227

20,985

$ 3,346 1,762 2,951 1,230

21,007

NAFT A-Induced Change (%)

+0.1 0.0

+0.2 +0.2 +0.1

Source: Cox, T., "Measuring the Regional Effects of U .S.-Mexico Dairy Trade Under N AFT A, n Paper Presented at International Agricultural Trade Research Consortium Annual Meeting in San Diego, CA on December 12-14, 1993.

The results shown are estimates of changes from the 1989-92 base period revenues that would occur after the N AFf A has been in effect for five years. The increases in revenues occur because of larger exports of nonfat dry milk, other manufactured products including dried whey, and fluid milk.

The revenue increases described in Table 6 translate into small or zero farm milk price increases. For Wisconsin, California, and the West South Central region, the increases would be $.01 to $.02 per hundredweight. For the West North Central region, the increase is zero. Recognize that different assumptions and changed conditions would produce results different from those shown. The key conclusion to draw from these figures is that under "best guess" assumptions about Mexican import demand, the effect of the NAFfA will be small. In part this is because U.S. dairy exports to Mexico are already relatively large and will increase only marginally under the NAFfA.

The results in Table 6 are broadly similar to those obtained by the USDA. As noted earlier, the USDA forecast that the value of U.S. dairy exports would be about $63 million higher with NAFfA than in the absence of NAFfA. This $63 million translates into about $0.04 per hundredweight when spread across U.S. milk production for 1992 which totaled 151.7 billion pounds. The $63 million would be shared by dairy farmers, processors, exporters, transportation firms and others. Thus, probably only $.01 or $.02 per hundredweight of the NAFTA-induced increase in dairy exports forecast by the USDA will find its way into farmers milkchecks.

The limited impact of the NAFfA should not be confused with the overall impact of dairy exports. At times, dairy exports contribute substantially to higher producer milk prices. For example, expanded exports under the DEIP in 1992 were estimated to have added $.55 per hundredweight to farm milk prices in 1992 [12]. Much of this increase was associated with larger exports of nonfat dry milk. While the expanded exports of nonfat dry milk probably originated mostly from California and other Western states where most of this product is manufactured, the impact of higher nonfat dry milk prices was felt in the Midwest as well. Note how 1992 prices for nonfat dry milk in the Midwestern region parallel those in the Western region (Figure 2).



Figure 2. Weekly Prices of Nonfat Dry Milk in the Central and Western Regions of the U.S., 1992

1.20~--------------------------------------------------~ #' •• ', . . .' . . .

:" " .... "".-'. . . : . ....... \"

: \

1.15

1.10 :./'" \.., : ........................ .

1.05

1.00

. . --.-0.95

0.90

0.85 1 st

. . . . . ,--- ."

,.,.# . . .

uarter

. . . . . . . . . : ' .. " . .

2n uarter 3r uarter

Source: U.S.D.A., AMS; Dairy Market Statistics, 1992 Annual Summary.

Babcock Institute Discussion Paper No. 94-1

Central Region

Western Region

4th uarter

21


PARTll

WILL IT BE PROFIT ABLE FOR UPPER MIDWESTERN FIRMS TO EXPAND

DAffiY EXPORTS TO MEXICO UNDER THE NAFT A?

The analysis in Part I indicated that (1) the NAFfA itself is likely to have little impact on sales and revenues of Upper Midwestern dairy firms and (2) if Upper Midwestern dairy firms expand dairy exports to Mexico, the expanded sales are likely to consist substantially of differentiated dairy products.

Whether it will be profitable for Upper Midwestern dairy firms to initiate or expand exports of dairy products to Mexico depends on factors specific to individual firms. Producers of specialty cheeses, pharmaceutical lactose, and other high-value differentiated products might well consider Mexico and other foreign markets as profitable outlets for additional product. Lack of proximity would be a limited deterrent to expanding exports of these prOducts to Mexico. Upper Midwestern processors could expand sales of bulk cheese and milk powder for the Mexican market under the DEIP program. But, if such expansion involves no more than serving as a supplier to an ECbased firm, this indirect exporting may be a low profit margin initiative. Finally, if world market conditions similar to those that emerged in 1988-89 reappear, Upper Midwestern firms could supply milk powder to Mexico without subsidy. But product mix and proximity considerations would limit the amount of these exports. Moreover, profits obtainable under such a scenario will depend on whether the firms serve as suppliers to EC-based exporting firms or engage in direct exporting.

For reasons noted earlier, many Upper Midwestern dairy firms will find it profitable to sell in the domestic market or to the USDA under the price support program. But, others may find it profitable to devise a long-term strategy that gives them direct exporting experience. Because of proximity, Mexico may prove to be one of the best places to gain such experience. This would help the firms partially eliminate the early mover advantages that have been gained by border state firms, EC-based exporters, and the New Zealand Dairy Board.

The information in Table 7 identifies practices selected firms have used to serve the Mexican market. Export marketing information that Upper Midwestern firms might extract from Table 7 includes the following:

• Dean Foods Company -- Represents orthodox strategy used by fluid milk and "soft" dairy products processor to enter the Mexican market. Upper Midwestern firms probably could obtain such sales only by acquiring an equity interest in a similar firm.

• Foremost In/Uedients Unit of Wisconsin Dairies -- Representative of small exporting operation for differentiated dairy products that is operated by an Upper Midwestern dairy firm. A few other Upper Midwestern dairy firms have broadly similar exporting operations. The number of Upper Midwestern firms making sales to Mexico similar to those made by the Foremost Ingredients Unit presumably could be expanded.

• Baskin-Robbins, Arby's and Domino's Pizza -- Representative of specialized markets for differentiated ice cream and cheese that could be available to Upper Midwestern dairy processors. Baskin-Robbins made use of joint venture to enter Mexican market. Arby's and Domino's Pizza would require delivery to demanding specifications.

• New Zealand Dairy Board (NZDB) -- Illustrative of strategy of experienced, unsubsidized exporter of differentiated and bulk dairy products. The expansion of the NZDB operation in Mexico involved initially establishing a joint venture



business and subsequently buying out the joint venture partner to establish a wholly-owned NZDB subsidiary. This represents a standard market entry practice for the NZDB. The Board's actions suggest that it regards Mexico and Latin America as growth markets. The NZDB also could be a conduit for Upper Midwestern dairy products sold in Mexico since the Board often obtains dairy products from non-New Zealand sources.

• M.E. Franks -- Representative of EC-based fIrms that sell bulk dairy products in Mexico. M.E. Franks has investigated entering into joint arrangements with Upper Midwestern dairy cooperatives to obtain dairy products for export to Mexico and other foreign markets. To date, formal joint arrangements have not materialized.

U sing joint ventures to enter the Mexican market, as done by several of the firms indicated in Table 7, is noteworthy. The President of the International Division of Ault Foods of Canada explained the popularity of joint ventures as a vehicle for entering a new foreign market in these terms [22]:

"Joint ventures are the best way to go. You must have the benefit of local experience. We're not short of money, but short of experience in these countries, and we want to minimize risk."

Upper Midwestern firms interested in exporting dairy products to Mexico will find numerous sources of information on the subject. Information suppliers include the National Dairy Board (NDB), U.S. Small Business Administration, International Trade Administration Office of the U.S. Department of Commerce, The U.S. Export-Import Bank, and the Agricultural Export Service of the USDA's Foreign Agricultural Service.

The NDB has carried out market research on Mexican demand for dairy products, emphasizing market studies for dairy desserts, yogurt, cheese, whey and lactose. These studies contain many practical do's and don't regarding exporting and detailed information on the Mexican market. The NDB, for example, emphasizes the need to regard exporting to Mexico (or any other foreign market) as a long-term proposition rather than as a way to dispose of temporary surpluses. Examples of market information obtained by the NDB regarding the Mexican cheese market are as follows [20,29]:

• Consumption of U.S. cheeses in Mexico is constrained by a lack of familiarity on the part of middle and upper income Mexican consumers with U.S. cheeses.

• NDB information showed that retail prices for imported cheeses were similar to U.S. prices. The NDB study also suggested that middle and upper income people in Mexico are price sensitive. In particular, it was found that 33% of Mexican consumers who had previously purchased imported cheese had not repeated those purchases because of the perceived high price of the imported product.

The National Dairy Board and National Milk Producers Federation have developed a proposal for a U.S. Dairy Export Federation [6]. When fully operational, this large organization would include dairy processors, dairy cooperatives, national commodity promotion organizations, state/regional commodity organizations; industry, trade and farm associations; export trading companies, and supply and service organizations. The organization is designed to coordinate exporting efforts and serve as a sounding board for issues that significantly constrain U.S. dairy exports. The newness of the organization makes it diffIcult to assess whether it will help Upper Midwestern dairy firms expand exports to Mexico and other markets.



Table 7. Exporting Practices of Selected Firms SeJJing Dairy Products in Mexico.

Firm

Dean Foods Co. [4]

Foremost Ingredients Unit of Wisconsin Dairies Cooperative

Baskin-Robbins [7]

Exporting Practices Including Products Sold

Entered Mexico about five years ago by forming an association with a Mexican dairy. Initially supplied small grocery stores. This agreement was replaced with a dairy broker which has placed Dean's dairy products in major retail grocery chains in Mexico. Customers include large Wal-Mart store in Mexico City.

Foremost Ingredients Unit was acquired by Wisconsin Dairies in 1984. Value of total dairy exports to Mexico and more than 20 other countries equals 1% to 2% of Wisconsin Dairies' sales. Sells lactose to pharmaceutical manufacturers and infant formula makers in Mexico. Have sold whey protein concentrate and feed grade whey powder to Mexican customers.

Opened ice cream scoop shops in Mexico City, Monterey, Guadalajara, Acapulco, and Guernavaca under a joint venture with Quan Group. The Quan Group is a Mexico City based ice cream franchising company that operates 200 ice cream outlets.

Arby's and Domino's Pizza Are opening stores in major cities in Mexico. American [26] Embassy dairy report identifies these outlets as potentially

important markets for U.S. cheese.

New Zealand Dairy (NZDB) [21]

M.E. Franks [9]

Supplier of nonfat milk to CONASUPO. In 1991, the NZDB brought out its joint venture partner in Aranz. The new wholly-owned subsidiary of the NZDB will focus on consumer and ingredient products. This NZDB subsidiary has installed a pilot-scale manufacturing plant in Guadalajara for food industry trials for Latin American customers.

Formerly a U.S. company, M.E. Franks was acquired in the early 1990s by a Belgian finn. M.E. Franks is one of the largest sellers of milk powder to CONASUPO under the DEIP program. Competitors of M.E. Franks have commented on the low bids it submits for DEIP export sales.

Upper Midwestern dairy cooperatives have included dairy export expansion as an objective for the Dairy Marketing Initiative (DMI). Participating cooperatives will investigate whether the DMI should be used to share information on needs of foreign customers, provide other market intelligence, coordinate dairy exports, and achieve other objectives. As with the U.S. Dairy Export Federation, it is too early to tell how much this



initiative will help Upper Midwestern cooperatives expand dairy exports to Mexico and other markets.

While Upper Midwestern dairy firms may find the NDB, government export assistance agencies, the U.S. Dairy Export Federation, and cooperatives participating in the DMI helpful; these organizations and firms will not substitute for experienced personnel. Firms wishing to compete successfully with the NZDB and EC firms probably will find it necessary to hire experienced personnel to carry out exporting initiatives. The staffing of M.E. Franks is illustrative. Its CEO is a former official of the New Zealand Dairy Board. The finn's Director of International Sales has experience with EC dairy exporting.

There is no simple answer to the question of whether it would be profitable for Upper Midwestern dairy firms to initiate or expand dairy exports in the Mexican market. Most firms in the region probably will find it profitable to concentrate on selling in the domestic market. Those who opt to sell dairy products in Mexico have many sources of information on the market. They also have numerous strategies available for expanding those sales, including indirect exporting, joint ventures, the DMI, and the DEIP. Upper Midwestern dairy firms may discover that small-scale or experimental exporting to Mexico makes sense as part of a long-term strategy for overcoming early mover advantages gained by border state and foreign exporters.

Babcock Institute Discussion Paper No. 94-1 2S


References

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25. Suber, T., "Comments Made at Dairy Export Mini-Conference Sponsored by the Wisconsin Federation of Cooperatives," Madison, Wisconsin, November 15, 1992.

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