Exchange Rate Lessons from Australia’s Wine Boom and Bust

Kym Anderson (with the assistance of Nanda Aryal), Growth and Cycles in Australia’s Wine Industry: A Statistical Compendium 1843-2013). University of Adelaide Press, 2015. (Available as a free pdf download — follow the link above.)

ozKym Anderson’s new book on the five major boom-bust cycles of the Australian wine industry is a landmark wine economics study. Like all of Anderson’s work, it is data-driven and provides both the casual reader and focused student with a wealth of information.  A detailed Executive Summary is followed by 73 pages of analysis (and ten more of references), 86 revealing charts and more than 450 pages of tables.

Answers and Questions

I’m not sure I have ever seen such a detailed account of what happened to a wine industry, when, where and how. The data span the decades, regions, grape varieties, international regimes and economic cycles.  Such a wealth of information is valuable both for its ability to answer questions and for the way that it provokes them.

I won’t attempt to summarize Anderson’s big volume here (Andrew Jefford did a great job of this in his Decanter column) but I thought I might illustrate the sort of focused analysis that the book makes not just possible but convenient.  We are always looking for lessons from history and I think Australia’s wine business cycles are useful in this regard, especially the fifth cycle, which began in 1986 and continues today.

Exchange Rate Effects?

Anderson describes the recent collapse of the Australian wine industry as the result of a “perfect storm of shocks” including drought and rising irrigation water prices, the global financial crisis, the rise of the Australian dollar (driven by mineral exports to China), increased competition from other wine-exporting countries, and China’s austerity policies (which have reduced demand for luxury wine products). He could have added vineyard  heat spikes, wildfires and the gradual but significant effects of global climate change to the list of challenges. Perfect storm, indeed!aud

Since we are currently experiencing a period of major exchange rate realignment, with the U.S. dollar on the rise and the Euro seemingly in free fall, I thought it would be useful to tease out the many ways that the Aussie dollar impacted its wine industry in recent years.  According to news reports currency instability was the hot topic at the ProWein wine fair this year, so analysis of the possible effects is timely. Here are some brief points taken from the Executive Summary.

  • The 1986 boom began, Anderson tells us, as a response to the historically low value of the Australian dollar (hereafter abbreviated AUD), which encouraged exports by reducing their price to foreign buyers. The AUD’s low value was due to falling prices for mineral exports.
  • Wine exports boomed, rising to 2.3% of all Australian exports by 2004.
  • Wine prices increased, stimulating vine plantings, higher production and more exports but higher prices also  limited domestic wine market growth making Australian producers more dependent on export markets.
  • Rising exports increased the incentive for investment in developing overseas markets for Australian wine, both through generic marketing and private brand promotion. Meanwhile, other countries also began to expand wine exports, too, contesting key market spaces.
  • The AUD began to rise in 2001 (driven by Chinese mineral demand). Competition in export markets made it difficult to pass through rising foreign exchange costs to export customers, so much of the burden was passed back in the form of lower AUD export receipts and, in due course, lower wine grape prices.
  • Meanwhile, the strength of the AUD made imports cheaper, including wine imports, which increased dramatically. Especially affected were Sauvignon Blanc imports from New Zealand and Champagne imports from France.
  • New Zealand Sauvignon Blanc became the best-selling white wine in Australia. Not the best-selling imported white wine. The best selling-white wine, period!
  • Wine grape prices collapsed and the value of vineyard land fell, in some cases to the same low value as unimproved farm land. This is the bust that the Australian industry is still recovering from.

Lessons for the U.S. Today?

The exchange rate isn’t the whole story of Australia’s fifth wine cycle by any means, but you can see that it had important effects. The long term instability in the exchange rate translated into booms and busts in wine exports, imports, wine prices, grape prices, land prices and so on.

Anyone who thinks the current rise of the U.S. dollar won’t impact the U.S. wine industry or have global repercussions should take a look at Anderson’s study of Australia. The U.S.story will be different, and the impacts less just because our domestic market is so much larger, but there will be significant impacts.

This is just one of the analytical threads in Kym Anderson’s important new book. I invite you to dig and see what questions his work raises and what lessons you can learn.

How Will the Rising Dollar Affect the U.S. Wine Market?

fxHow will the rising dollar affect the U.S. wine market? The answer, predictably, is that it’s complicated. Read on for analysis organized around three questions. Why has the dollar appreciated? What are the textbook effects of a rising dollar? How and why is the impact on U.S. wine likely to be different?

Why has the dollar appreciated?

The U.S. dollar has appreciated dramatically on foreign exchange markets, powered by several factors. Expectations of higher interest rates in the U.S. is a big part of the story as the reality of the end of the Federal Reserve’s asset purchase program sinks in. Add to this the fact that the Europoean Central Bank is finally close to beginning its own quantitative easing program, which will keep rates down on that side of the pond. This combination is a recipe for the sort of change you see in the graph above.

The relative strength of the U.S. economy, weakness of the E.U.with its potential “triple dip” recession and uncertainty regarding China and oil prices all contribute to the economic environment that has helped fuel the dollar’s recent rise. Where is money going to go in a risky world? Can you say USA? A lot of us have been impatiently waiting for the dollar to move higher for a couple of years. Now that it has happened, what should we expect?

What are the textbook effects of a rising dollar?

The classic textbook effect of a rising currency is that imports increase because they are relatively cheaper and exports decline because they are costlier to those holding foreign currencies. Imports up, exports down. That’s where the Econ 101 story often stops, but the situation is a little more complicated.

Prices adjust faster than quantities in most cases. Price effects (rising export costs, falling import prices) tend to happen quickly, but quantities take longer to change because of inventory lags, recognition lags, and contract lags. Basically, it takes time before the new exchange rate translates into real actions because existing inventories must be depleted before new orders are made, because it takes some time before economic actors feel certain that the change is sustained and not just a market blip, and because existing contracts often preclude immediate adjustments.

These lags create what economists call the “J curve” effect, with opposite short-term and long-term payments impacts. The Econ 101 results take longer to show up in significant amounts than you might think and even then will only appear if other intervening economic factors don’t offset them. So predicting the short term impact of an exchange rate change isn’t as simple as you might think even if you earned an “A” in Econ 101.

But price is a powerful force, and the fact that a rising dollar makes our exports more expensive to foreign purchasers (and imports cheaper for U.S. buyers) should not be ignored even if immediate run impacts are not obvious. Don’t expect everything to change at once.

One more complication is that although we like to talk about the dollar rising or falling, the overall trend conceals the fact that the dollar might be higher relative to one currency and still falling compared to another. During one recent period when the dollar was quite weak by some standards, for example, it still rose compared to some other currencies that were even weaker.

How and why is the impact on the U.S. wine markets likely to be different?

Given all this, it is instructive to read a 2012 report by Kym Anderson and Glyn Wittwer titled “Studying the impact of exchange rate movements on the world’s wine markets, 2007-2011” (a University of Adelaide Wine Economics Research Centre working paper — the link takes you to a pdf of the paper). The Anderson-Wittwer study examined the impact of exchange rates on wine trade during a period when the dollar was falling instead of rising and finds that the impact of exchange rates was different in different import markets and in different wine market segments. (I told you it was complicated!)

In the U.K. market, for example, the exchange rate impacts were pretty much what theory suggested both in terms of import effects and distribution among different wine exporting countries. A good textbook case.

But the U.S. was a different story, as you might expect given that we have a substantial domestic wine production base and that we both export and import wine with the two trade flows connected to a certain degree by the “wine drawback program”  (Click here to read a 2012 UC/Davis report on the drawback program.)

The wine drawback program allows a refund of 99% of import duties and excise taxes on wine for which the importer has matching exports of commercially “interchangeable” wine. Because per-unit import duty and excise tax rates are substantial compared to the price of bulk wine, use of the program is high for bulk wine imports, which compete with wine from low-price Central Valley grapes. Bulk wine exports dominated imports until 2009 and the program stimulated import growth. Now, with imports and exports roughly in balance, the program stimulates both exports and imports—leaving net trade in bulk wine roughly in balance.

– Summary of the U.C. Davis Report

The Anderson-Wittwer study found that the falling dollar had different effects on U.S. consumption of  Old World and New World wine imports during 2007-2011. Old World imports increased despite the dollar’s fall and New World imports fell.  Obviously the price effects were more strongly felt for New World wines than for Old World products (see Table 6 of the report) and although Australia accounted for much of the import decline and may be a special case in some ways, Argentina, Chile and South Africa were also negatively affected.

The study found differences by price category, too. Non-premium and commercial premium New World wines were the most affected by the exchange rate changes while super-premium wines showed less impact. This makes sense because the lower priced products are often part of the bulk wine trade, which has become highly efficient, facilitating ease of substitution from one country’s products to another. A small change in cost can have a big impact on the size and direction of trade. Textbook effects rule here.

More expensive products benefit from greater product differentiation. The power of an established brand acts as a shock absorber when costs increase, although there are obvious limits to this.

It’s Complicated

So if Old World imports increased and New World imports fell during the period when the dollar was slumping, can we expect just the reverse now that the dollar is soaring? It would be great if we could just take the Anderson-Wittwer numbers and change the signs from plus to minus and so forth, but life is more complicated than that. Anyone who has tried to sell wine can tell you that it is easier to lower a price than to increase it! It’s a kind of hysteresis in the sense that where you can go now depends on where you have been. You can’t just back out to where you started.

That said I think there are important insights to take away here, key among them is the idea that the impacts are likely to be different for bulk wine and packaged good trade and for Old and New World products.

Textbooks and research give us good guides to understanding the impacts, but there aren’t any simple answers. And the exchange rate isn’t the only thing that’s changing this time around. I know a number of New World producers who made big bets on the Russian market, for example. Seemed like a good idea at the time, but my how things have changed! They’ll be desperately  looking for markets for the wine they can’t sell to Moscow. And imports from Argentina may be more affected by that country’s domestic policies (and the upcoming elections) than exchange rates.

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It occurs to me that this column is a classic example of what Paul Krugman once called “up and down economics.” This goes up, that goes down, and so on. Made me think of the Winslow Homer painting “Right and Left” that you can see in the National Gallery in Washington D.C.

Stein’s Law and the Coming Crisis in Argentinean Wine

Stein’s Law, named for famed economist Herbert Stein, holds that if something cannot go on forever it will stop.  Unsustainable trends ultimately yield to the inevitable in one way or another.

Stein’s Law seems to be simply stating the obvious, but you would be surprised how many people find a way to ignore the obvious when it is in their interest to do so.  As Upton Sinclair wrote, “It is difficult to get a man to understand something if his salary depends on his not understanding it.”

Argentina’s Inflation Problem

And so we consider the case of the Argentinean wine industry. It’s not just the wine sector, of course, it’s the whole Argentinean economy, but wine is especially affected.  Something’s going to happen according to Stein’s Law, because it can’t go on forever as it has up to now, but it is hard to know exactly what.

The problem begins with Argentina’s high inflation rate. The official statistic puts the annual increase in consumer prices at around 10%, but this number is viewed with disbelief by the international economic community. The Economist magazine quit publishing the official figure in 2012, saying “Don’t lie to me, Argentina” to the officials there. The most commonly cited estimate of the actual inflation rate is 25% per year.

Inflation is a sensitive political issue in Argentina as it is in every country that has ever experienced a hyperinflation crisis (think Germany, for example). Some in Argentina go to great lengths to deny the obvious reality of inflation.

The story (which may be true) is told about a McDonalds restaurant in Buenos Aires that displayed all the usual products on its big backlit menu board except the signature Big Mac. Where’s the Big Mac? Oh, we have that price hidden around the corner so that no one will see it — especially the people from The Economist magazine who use it to estimate the purchasing power of the peso in their Burgernomics index!

Inflationary Squeeze

As a recent article on The Drinks Business website suggests, high inflation is putting the squeeze on Argentina’s wine producers. (The squeeze is made worse,  I understand, by government policies that restrict imports of products used in wine production as part of a general policy to control foreign exchange reserves). Production costs (grapes, labor, etc.) may have doubled over the past four years, putting a squeeze on margins.

It is difficult to pass these peso costs along to consumers in the U.S., Canada, the U.K. and Brazil, the main export markets. Consumers are price sensitive and while the average export price of  varietal Cabernet and Merlot wines have risen by 7.2% and 24.8% respectively in the past year, this provides only limited relief from rising costs since Malbec takes the lion’s share of the export market and its dollar export price has risen by just 1% in the last year and by an average of only 2.8% per year since 2009.

Purchasing Power Inaction

The textbook remedy to this situation is for the foreign exchange value of the peso to fall to achieve what economists call Purchasing Power Parity. In a system of market determined exchange rates, according to the PPP theory, a 25% fall in the domestic purchasing power of the peso due to inflation should result in a 25% decrease in its foreign exchange value.

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And indeed the peso has depreciated, but not by nearly enough to overcome the inflation difference between Argentina and the four main export markets. The peso has fallen in value by about 20% in the last two years, if we look at the official exchange rate, so each dollar of export earnings brings in more pesos,  but inflation-driven peso costs have increased by much more.  That puts a real squeeze on margins. This can’t go on forever — something has to give.

[I’m told that the black market exchange rate is 8 pesos per U.S. dollar, far below the official rate of about 5 per dollar. Such a big differential is often an indicator of crisis to come.]

Something’s Gotta Give

What happens when a country gets itself caught in a squeeze like this? Well, the conventional wisdom is there needs to be a sharp currency devaluation followed by monetary tightening to control inflation. This is a painful process and Argentina has been through it before. What if the government ignores the conventional wisdom? Internal adjustment must eventually take place to restore competitiveness if external adjustment through the exchange rate is ruled out.

A recent Wall Street Journal article about real estate prices in Buenos Aires shows one pattern of adjustment. The dollar prices of luxury apartments have tumbled as owners seek to cash out of their real estate investments and buy into the more credible U.S. currency.  The WSJ reports that

In May last year, Argentine President Christina Kirchner strictly limited access to U.S. dollars and other foreign currencies in a bid to stem capital flight. With the Argentine peso facing about 25% annual inflation (government figures, widely discredited, set the rate much lower), and an unofficial exchange rate that has effectively devalued the peso sharply, demand is high for dollars.

These days, the main feature that foreign buyers say they look for in a Buenos Aires property has nothing to do with closet space or a wide terrace. It is a seller with a bank account outside Argentina to which they can legally wire funds. This is a way to get around having to convert any dollars wired into Argentina into pesos at the official rate, after which it is nearly impossible to convert back into dollars at the official rate.

Something will have to give in the wine industry, too, if the exchange rate doesn’t adjust and the currency controls continue. In the meantime, I think every effort is being made to control costs and to keep margins out of the red. But, as Herb Stein might say, this can’t go on forever so somehow it will stop.

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Herbert Stein may be best known today as father of Ben Stein, the actor, law professor, and columnist, but he was ever so much more famous in his day as a chairman of the president’s council of economic advisers

Little known fact: the Pabst beer company held an economics competition in 1944 (the year of the Bretton Woods conference)  for the best plan to sustain high employment in the post-war era. Herb Stein’s plan was named the winner from among the more than 36,000 entries. He was 28 years old and the prize was $25,000 — the equivalent of $330,000 today.

Argentinean Wine: A SWOT Analysis

The first thing we did when Sue and I arrived in Mendoza was to walk to the offices of Área del Vino, the group that publishes Vinos y Viñas magazine, the WineSur website and provides economic and strategic analysis to the wine industry here. We met with Javier Merino, Área del Vino director, and Gonzalo Merino, director of WineSur. They got our visit off to a flying start.

Our discussion was wide ranging. Gonzalo is working on new media projects to expand the market for Argentinean wine and reach a new generation of consumers. Javier was just back from Hong Kong and China and keen to discuss the potential new markets there. Both were happy to talk about controversial questions, such will the Malbec boom be sustained and whether Torrontés really is The Next Big Thing.

Their analysis has been very useful to me as I have met with wine-makers, winery owners and managers. Based on all these discussions I have prepared this SWOT analysis, which represents my current thinking about Argentinean wine today. This is a work in progress (and necessarily very brief), so I welcome comments that correct my thinking or re-direct my analysis.

Strengths

Argentina has many strengths. The most important may be that it has a “hot” brand, its signature Malbec. When wine enthusiasts think of Argentina they think of Malbec and vice versa — a strong identity that many wine regions envy.

But, as I will explain in future posts, Argentina is not just Malbec (or even just Malbec and Torrontés as some writers propose).  Quality extends across a broad spectrum of wine varieties, styles and price points, which is a very good thing.

Weaknesses

That said, the industry is very dependent upon exports of Malbec to three main markets, the United States, Brazil and Canada.  There would be trouble if Malbec exports to these markets were to falter due to either a decline in demand to a shift to some other “hot” variety.

The domestic market for wine is very substantial, but it is still dominated by low-price basic wines — another weakness. The Argentinean industry would be much stronger if a larger domestic market for quality wines could be developed.

Water is also an issue here as it is in many wine regions. Not an issue today, Javier told me, but for the future. And of course the future is fast approaching.

Threats

There are a number of very serious economic threats that cloud the short term outlook. Domestic inflation is high in Argentina. The government estimate is about 10%, but I failed to find anyone who thinks that it is less than 25%.  Production costs are rising rapidly– labor, grapes and other inputs are increasingly expensive. Land prices for new vineyard projects seem to be growing exponentially.

Revenues are not increasing at the same rate, with the result that margins are being squeezed.  In fact, the pressure is on to cut prices in the competitive U.S. market. It is not clear how long the current combination of rising costs and falling revenues (or soft revenue growth) can be sustained.

I visited several wineries that were clearly focused on increasing efficiency in an attempt to claw back margin without sacrificing quality.  But I also heard rumors of wineries that were taking the perhaps desperate move to source lower cost grapes from other regions to stay in business. The concern was that quality would suffer and The Brand undermined.

Opportunities

There are many opportunities and they fall into two categories: new wines and new markets. By new wines I mean a movement to expand Brand Argentina beyond value Malbec, both into the higher reaches of the wine wall and into other varietals. I’ll be writing more about this in future posts.

I’ve already written about the new markets. As I listened to Javier discuss the great potential in countries like Brazil, with large and growing populations and fast economic growth I knew just what he was talking about: The BRICs (and the New BRICs). Javier believes that the BRIC-like markets  are the key to the next stage of Argentina’s export growth. Because geography still matters in both wine and economics, Brazil is a particularly attractive target, but both Hong Kong and China are high on the list.

Argentina’s China card is that its wines could fill an open market niche. Not cheap bulk wines like those from Chile and Australia. And not overpriced prestige labels like those from France. Quality Malbec from Argentina would be more affordable (and in most cases better) than the French and of course much better than the bulk wines. Distinctive, too, on several dimensions.

But China’s a tough market to break into, as I have said before.  China will require patience and good luck as well as good wine.

The new market with the greatest potential for Argentinean wines may be Argentina itself.  Nearly everyone I talked with said that the best thing that could happen would be for the domestic market for quality wine to expand, making the industry less dependent on exports and less vulnerable to inflation and exchange rate changes.

Bottom Line Analysis

So what’s the bottom line? Well, of course, I believe that the long run opportunities are important, but it seems to me that the short term threats are on everyone’s mind right now, in particular, the inflation-exchange rate squeeze. If inflation continues at high rates and the U.S. dollar – peso exchange rate stays stuck at about 4 pesos per dollar, some producers here will be squeezed out of the U.S. market. Perhaps they can sell to Brazil or on the domestic market, but the prospects are not good if everyone tries to shift focus at once.

What is keeping the exchange rate stuck at an over-valued level? Politics and fear, I suppose. There’s a presidential election in the fall and everything here has taken on a political significance, so it is no wonder that holding the line on the exchange rate (and denying that an inflation problem exists) would be political, too.

And then there is the fear.  Argentina has experienced inflation-devaluation vicious cycles in the past. Inflation leads to a falling currency, which adds to inflation pressures, which forces the currency down even more. Etc, etc.  There’s a worry here that lowering the exchange rate would set the cycle off once again and nobody wants that.

Fear and politics are powerful forces. Argentinean wine, for all its strengths and opportunities, is caught in the squeeze.

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Thanks to Javier Merino, Área del Vino director, and Gonzalo Merino, director of WineSur for meeting with us in Mendoza and to everyone who has talked with us about wine economics in Argentina during our stay here.  Watch for future posts that examine particular elements of the Argentina wine story in more detail.

Vineyard Plague: The Dutch Disease

As if things weren’t bad enough in Australia, now there’s this: the Dutch Disease. No, it isn’t a fungus spread when you plant tulip bulbs in the vineyard or something you saw on the television series House MD. It’s much more serious than that. And it’s hitting South Africa, too. Look out!

Australia’s Perfect Storm

I’ve written several times about Australia’s continuing wine crisis. It seems like everything that could go wrong has gone wrong. Too much heat, too little water, excess capacity, collapsing demand — even smoke-tainted grapes caused by runaway brush fires. Yikes!

Now there is more bad news and it’s the result of too much good news? Good news is bad news? Yes. Read on.

The Dutch Disease is the name economists give to the problem of too much good news in one industry and its negative impact on the rest of the economy. If one sector of the economy gets hot on global markets (think oil exports, for example) one effect can be that export sales increase the demand for the country’s currency, causing it to appreciate in real terms. The rising currency value makes all the nation’s other products more expensive on foreign markets, sending them into a tail-spin.

The Good News the Bad News

That’s how good news in one part of the economy can backfire. The Economist magazine apparently invented the term to describe the dilemma of the Netherlands after a big gas field was found there in 1959.

The good news / bad news in Australia is clearly the fact that China’s economy is growing rapidly and sucking in the natural resources that Australia has in considerable abundance. But big purchases of the Australian dollar needed to pay for these products has pushed the currency up, making Australian wines more expensive here in the U.S.

This helps explain why off-premises sales of Australian wines are still falling here even though many other segments of the wine market are recovering. Recent Nielsen retail data show the U.S. wine market growing by 4.3 percent in the period ending in August, but sales of Australian wine fell by 7.5 percent (data from the November issue of Wine Business Monthly).

As the chart above shows, the Australian dollar has continued to appreciate since these data were compiled, magnifying both the Dutch Disease problem and the sense of crisis in the Australian wine industry.

South Africa Also Hit

South Africa seems to be experiencing the Dutch Disease as well. There are many factors that have contributed to the sharp rise of the Rand against the dollar, but surely the surge in gold prices must be the most important one. As speculators and investors who have worried about inflation turn to gold, their purchases have driven up the value of South Africa’s currency as well.

This helps explain why sales of South African wine in the U.S. have been in a bad slump. Nielsen data indicate that South African wine sales fell by 8.3 percent in August and by 9.4 percent in the last year.

The U.S. dollar’s rapid recent fall will affect all countries that depend on our huge markets for exports, but inevitably some will be hit more than others.  Those like Australian and South Africa who suffer the Dutch Disease will be challenged the most.

We’ve entered an era of extremely unstable currencies, reflecting both the inherent instability of international financial flows and the increasingly cut-throat battles in the global currency wars. Inevitably many industries — including wine — will get caught in the cross-fire.

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Big Squeeze on Small Wineries in Argentina

Argentina is generally seen as the big winner in the current U.S. wine market. Sales of Argentinean wines have surged at every price point led by the signature Malbecs, (something that I wrote about in a recent post).  The big picture is great — perhaps the New World’s biggest success story since Marlborough Sauvignon Blanc hit the scene.

Both Sides Now

The devil is in the details, however, and a more detailed analysis of Argentinean exports suggests that some parts of the industry are facing significant challenges. As usual, my source for news and analysis about wine in Argentina is WineSur, which reports that small wineries are really feeling the squeeze in the critical U.S. export market. (See the report by Gabriela Mazilia. )

Small producers are what economists call “price-takers.” They cannot do very much to control the prices they receive on the export markets and they don’t have much control over input prices, either. While a great many business decisions are theirs to take, some of the most critical factors are beyond their control. This is true for all businesses, of course, but more so for some than others.

Mazilia’s report suggests that small Argentinean producers are feeling the squeeze from both sides of the market. Costs are rising rapidly, perhaps especially for the goods and services that winemakers require. Argentina’s  inflation rate is about 10% according to official statistics, but unofficial estimates put the number at about 25%, amongst the highest in the world today. Yikes!  The Economist‘s Big Mac Index reports that Argentina’s currency is much less undervalued now than a year ago even though the exchange rate has depreciated, which is consistent with rapidly increasing local prices.

Magnified Price Effects

Small producers would like to pass higher costs forward to consumers or backwards on to input suppliers, but neither of these options seems possible at this time. Mazilia’s report suggests that export price increases of 5%-10% are possible for wines that retail in the USD 10-18 range, where Argentinean wines are seen as good values. Increases for more expensive wines are apparently out of the question — the market for $20+ wines in the U.S. is just too competitive, too filled with expensive wines selling a a discount.

One problem Argentinean exporters face is that every 10% increase in the price they receive is magnified in absolute terms as the wine passes through the supply chain. One producer cited the dismal math that a USD 1 increase in FOB export price translates into a USD 4 increase in retail prices. Here is an example from the WineSur report:

A case in point is the winery Sur de los Andes. The firm’s owner and manager, Guillermo Banfi, announced: “In the course of this second semester we’ll raise prices from 5 to 10%, in particular in our line of classic wines. We won’t touch the prices of the great reserve line or of our icon wine. Margins have shrunk so much that there’s no way we can keep absorbing the high increase in costs.”

When asked how much of a margin of increase could be born by an Argentinian wine without losing market share, Banfi provided an example that illustrates the situation in the US, a reference market. “In the US, our wines in the USD 10-18 retail price segment sell very well – these are wines with an FOB price of USD 3-5. With an FOB price of USD 3, the consumer price is around USD 11. A rise of 5-10% would imply an increase of USD 1-2 in retail prices, which would have a negative impact on sales, since pricing is a very sensitive issue in this segment.”

Not Much Wiggle Room

Small producers are caught in a squeeze without much room to wiggle. If they don’t raise prices they will watch their margins disappear. If they do, well, they risk finding themselves in unfriendly market territory.

“The problem is that there will be a radical change of scenario for Argentinian wines in the USD 10-20 retail price range. Up to now, these wines have sold well because they are, on average, superior in quality to similarly priced European wines. But from now on, the gap in quality will be narrower, and we’ll be competing with wines of similar quality and price, from regions with a longer standing presence in the market.

Turbulent Tide

It sounds like Argentina’s small producers face an uncertain future, but this is nothing new. The great success of Argentina’s large international wineries in the U.S. market has masked a churning pattern among smaller winemakers. Each year several dozen small wineries enter the U.S. market, but each year others are forced to exit as the turbulent tide advances.

International connections, effective distribution, economies of scale and brand prestige are always advantages in competitive international wine markets. The are especially important to Argentina’s struggling price-taking small producers today.

Vinonomics: The Mouton Cadet Index

Richard Hemming, whose writing appears on the  Jancis Robinson website, has invented the Mouton Cadet index to measure international differentials in wine prices. It is an interesting project that is worth following.

Hemming’s price index, which he is calling Vinonomics (in homage to the Freakonomics craze), works like this. First he selected a high-volume wine that is in very wide international circulation to serve as the one-item “market basket” for his international comparisons. Mouton Cadet, the ubiquitous Bordeaux wine, is a great choice since it is so widely distributed (a “15-million-bottle, 150-country brand distributed from Andorra to Zimbabwe,” according to Hemming).

Mouton Cadet may not be the wine sold in the most different countries — Moët & Chandon Champagne would be my pick for that honor — but using Mouton Cadet keeps the Big Mac spirit of tracking the price of an everyday product, not a luxury good.

Sky High in Seoul

Hemming then searched the internet and other sources for prices of Mouton Cadet in as many countries as he could. He converted these prices to Euro, USD and GBP at market exchange rates and published them on the website. (He is hoping that readers will send in additional price data to help complete the table.)

The price differentials that Hemming finds are quite large.  The French ‘home country” price for Mouton Cadet is given as EUR 9.55, which is incredibly more than the reported price of the same wine in the United States (USD 7.99 or about EUR 6). Within the Eurozone, where trade is allegedly free, Cadet’s price runs as high as EUR 19 in Austria and EUR 21 in Italy. So much for the “Law of One Price!”

What’s the cheapest place in the world to purchase Mouton Cadet? So far Hemming’s low price leader is the U.S., where French wines struggle to sell in a crowded and very competitive market, followed by Hong Kong (EUR 8.56).

The most expensive? South Korea (EUR 26), Brazil (EUR 21.5) and Italy (EUR 21). The difference between the high and low price is stunning. It is easy to explain South Korea’s high price in terms of transportation costs, regulatory expenses and multiple middleman markups, but the high price given for Italy is difficult to understand. Hard to know who would pay so much for Cadet in Italy.

Bordeaux with your Big Mac?

Hemming’s research project is based on  the Economist’s famous Big Mac Index (BMI), which tries to measure the relative purchasing power of different currencies by comparing the local prices of McDonald’s ubiquitous hamburger.  Here is a table showing the index as of July 2010.

The table shows that Japan and Australia are very close to Purchasing Power Parity — the condition where a U.S. dollar has the same purchasing power abroad (when exchanged at market rates) as at home.  The dollar cost of a Big Mac is approximately the same in all three countries.

Norway’s currency is very over-valued according to the BMI.  A Big Mac that sells for USD 3.73 in the U.S. costs a whopping USD 7.20 (converting at market exchange rates) in Oslo. The high cost of buying a Norwegian Krone contributes to the hamburger’s high dollar price there.  The Swiss Franc is almost as over-valued — a Big Mac costs the equivalent of USD 6.19 in Geneva.

Hong Kong and China have undervalued currencies by this measure. A Big Mac costs less than the equivalent of USD 2.00 there. The harburger is cheap in part because the currency is so cheap in these countries.

Wine vs Burgers

The Big Mac index is far from a perfect measure of relative purchasing power, but it is not a bad guestimate because Big Macs are standard products with easily discoverable prices and most of the cost of producing a Big Mac takes place within the country in question. I’ve found that if the BMI says a country’s currency is over-valued then it probably is, although not necessarily by as much or little as the index suggests.

The Mouton Cadet index is very interesting for what it tells us about wine prices, but it is probably less useful as a measure of PPP. The wine, of course, comes from France unlike the locally-produced burger ingredients and the local price in South Korea, for example, is influenced by that cost basis (adjusted for exchange rate effects) plus transportation costs. The biggest “local content” factors are the local taxes and  wholesale and retail markups within South Korea, which are probably quite high.

Mind the Gap

At this point the Mouton Cadet index is most interesting to me for the questions it inspires (I’ve always said that questions are more interesting than answers). Who’s buying that EUR 21 Cadet in Rome (and are they interested in buying a bridge I happen to have for sale?)

What accounts for the high price in South Korea? The exchange rate is certainly  part of it. The South Korea Won is undervalued relative to the EUR according to the BMI. A Big Mac costs USD 2.82 in Seoul and USD 4.33 in Paris — a 50% price differential. The exchange rate therefore might explain 50% of the price gap between the Mouton Cadet price in France and South Korea. What accounts for the rest? (And does that fact that South Korea has no substantial domestic wine industry that I am aware of affect the mark ups on foreign wines?)

And what about Brazil? The Euro is actually  undervalued relative to the Brazilian Real according to the Big Mac index, and so the exchange rate is not necessarily a factor in Mouton Cadet’s high price in Rio. What other factors account for the big price gap?

I hope Richard Hemming continues with this project. It would be interesting to have data for additional countries (Japan? Russia? India?) and to see how the rankings change over time and relative to Big Macs.

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I’d like to encourage interested readers around the world to send Hemming local store prices for Mouton Cadet so that he has better data both for international comparisons and to get a sense of intra-country price dispersion.

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