The proposed Trans-Pacific Partnership (TPP) free trade agreement (FTA) among nine Pacific region countries was part of the agenda when New Zealand Prime Minister John Key met in Washington, DC last week with President Obama. Both leaders mentioned having a framework agreement ready by November when the Asia-Pacific Economic Cooperation forum is held in Honolulu. There is no indication they talked about New Zealand dairy exports, a sensitive issues for both countries.

According to estimates from the Foreign Agricultural Service (FAS) of USDA, in 2011 New Zealand will produce 18.0 million metric tons (MMT) of milk, 4.0 percent of the 446.7 MMT produced by the 13 largest producers. The EU-27 is the largest producer at 136.6 MMT, followed by the U.S. at 88.8 MMT, India at 52.5 MMT, Brazil, China and Russia each at about 31.0 MMT, and then New Zealand. New Zealand is generally accepted as the lowest cost producer among major exporters because of its pasture system. With 4.3 million people, New Zealand fluid consumption is 0.3 MMT. The remaining milk will be made into 2.1 MMT of cheese, butter, skim milk powder and whole milk powder, 97.5 percent of which will be exported and account for 37.4 percent of world trade on a product volume basis. According to the U.S. Agricultural Attach in New Zealand, milk products accounted for over 25 percent of New Zealand’s total export earnings in 2010. China was the top market for its dairy product exports at 17.4 percent of total shipments.

One agricultural cooperative, Fonterra, processes 89 percent of the milk supply according to the Attach’s estimate and is the world leader in dairy products trade. Fonterra was formed ten years ago from two cooperatives and the defunct New Zealand Dairy Board, a government controlled organization that had exclusive access to certain export licenses. Fonterra has also created a Global Dairy Trade auction platform through which it sold almost 25 percent of its production in 2010, up from less than 10 percent in 2009. It has invited other exporters inside New Zealand and internationally to use the twice monthly auctions, but California Dairies, a cooperative, is the only group indicating an interest in joining.

The U.S. has operated for decades with dairy product import quotas to protect the domestic market, and since the WTO came into force under the Uruguay Agreement in 1995 tariff rate quotes (TRQ) have been used. According to data from the U.S. Agricultural Attach, in 2010 New Zealand exported 96,439 metric tons (MT) of dairy products to the U.S., 4.2 percent of its total export volume, valued at $515 million, 6.3 percent of total export value. The U.S. was the fourth largest market for New Zealand on a volume basis after China at 401,600 MT, Philippines at 144,700 MT and Australia at 104,500 MT, but the second largest on a value basis after China at $1.39 billion and higher than Japan, Australia and Philippines each at about $400 million. Major imports to the U.S. on a volume basis were milk protein concentrates, butter and fat products and casein. The largest product for China was whole milk powder, Philippines skim milk powder, and Japan and Australia cheese. According to FAS data, U.S. dairy product imports from New Zealand on a value basis in 2010 were 22.0 percent of total dairy product imports.

The National Milk Producers Federation and other U.S. dairy interest groups have requested the U.S. government exclude dairy products from the TPP FTA. They consider New Zealand to be a forced exporter as demonstrated in the 2008/09 milk production year when they increased exports as market prices declined because of the small domestic market in relation to production. Fonterra is thought to have competitive advantages in TRQ markets like the U.S. because it has exclusive access to export licenses for high-value TRQ products. Fonterra also has product manufacturing and distribution relationships throughout the world which allow it to shift products from low-value markets to high value markets like the U.S. It is also producing milk in China, has plans to in Brazil and is considering India.

The position taken by the U.S. government on including dairy in the TPP free trade agreement is important. The Obama Administration has said that this agreement will be held to a higher standard than previous FTAs negotiated by the U.S. Trying to exempt an industry where the U.S. is not the lowest cost producer sounds more like a low standards agreement. Some supporters of the TPP agreement see the potential to expand it to countries like Japan, South Korea and other major economies in East Asia. If each demanded exemption of certain industries, the agreement would be less effective. New Zealand has its own interest in protecting its government drug-buying agency, Pharmac.

The concerns raised by the U.S. dairy industry should be taken seriously. It would be easy to ignore the dairy industry’s complaint because the U.S. is only 4. 2 percent of New Zealand’s trade in volume and 6.3 percent in value, particularly with the rapid growth of the Chinese market providing new opportunities for New Zealand. A business formed partly from a government board and now controlling 89 percent of the domestic milk supply is a cause for concern. Given that New Zealand has over a third of the world market for dairy products, higher for some products, and Fonterra operates in virtually every significant market in the world, its activities are important in the U.S. and world markets. The U.S. Trade Representative’s Office, USDA and other agencies should undertake a full investigation. Groups in New Zealand have also called for investigations on the domestic pricing power of Fonterra and want an independent price regulator. The New Zealand Commerce Commission is conducting a preliminary investigation.

The impact of domestic policies on trade in FTAs is a legitimate policy concern. A high standards FTA should include all products, including agricultural ones. Getting the facts straight on dairy industry concerns before an agreement is concluded is much preferred to catching-up after the fact. If changes are necessary in Fonterra’s structure or operations to remove features not consistent with free trade, those should be dealt with before an agreement is signed. If Fonterra does not have undue pricing power in export markets, New Zealand and Fonterra should be treated like any other country and trading firm.

Ross Korves is the Economic Policy Analyst for Truth About Trade & Technology.