inventory control - China Business Knowledge

When wealth grows on inventories

jingyipan@cuhk.edu.hk — Thu, 25 Apr 2024 02:00:22 +0000

Having an adequate stock of metal is vital for meeting demand in global industries. A new CUHK study reveals that it can also be utilised to make revenue

By Pan Jingyi, Principal Writer, China Business Knowledge @ CUHK

Metal is indispensable for modern machinery. As the world’s second-largest economy, China plays a significant role in metal production and consumption. The China Nonferrous Metals Industry Association data shows that the country’s output of 10 types of non-ferrous metals reached 74.7 million tonnes in 2023, up 7.1 per cent year-on-year.

While the country imposes tight controls on cross-border financial transactions, its global supply chain transactions remain widely open. Analysing data from China’s metal imports, a new study provided empirical evidence on how importers take advantage of low-interest overseas capital using their metal inventory to earn higher interest returns.

Different interest rates across countries or regions often present profitable opportunities for investors.

“When there are strict capital controls, we observe that firms use their imported inventory as a financial instrument to borrow cheaper capital from overseas credit markets in the form of trade financing,” says Vernon Hsu, Choh-Ming Li Professor of Operations Management of the Department of Decisions, Operations and Technology at The Chinese University of Hong Kong (CUHK) Business School.

Different interest rates across countries or regions often present profitable opportunities for investors, where they engage in carry trades – borrowing in a low-interest currency and investing in a high-interest currency. However, in financial markets with limited capital mobility, traditional financial instruments such as currency could be ineffective since these markets are relatively closed off from the global economy.

In the study, Professor Hsu and his colleague Wu Jing, Associate Professor from the same department, found that many importers bypass capital controls through their imported metals to make extra revenue. Specifically, the imported inventory is used as a financial instrument to take advantage of the different interest rates between US$ and Chinese yuan.

“Doing so allows them to earn financial returns by arbitraging differences between foreign and domestic interest rates,” says Professor Hsu. “This is an opportunity unique to importing firms, as China’s strict capital controls preclude the usage of traditional financial instruments, such as currency carry trade.”

“When there are strict capital controls, we observe that firms use their imported inventory as a financial instrument to borrow cheaper capital from overseas credit markets in the form of trade financing. ”

Professor Vernon Hsu

Dual roles of inventory

In a study entitled Inventory as a financial instrument: Evidence from China’s metal industries, Professor Hsu explains that inventory could play dual roles in a firm’s supply chain decisions. The first role is to match demand and supply, and the second role is as a financial instrument to take advantage of arbitrage opportunities in the international financial market.

Using inventory as a financial instrument involves three main steps. First, the importer obtains a loan in foreign currency from an overseas bank using trade financing tools such as a letter of credit (LC) provided by a domestic bank. This loan is used to purchase the product from the global market. Second, the imported inventory is either sold immediately in the domestic market or used as collateral to secure a loan in the local currency. The local currency is then invested in short-term assets offering higher returns. Finally, the importer collects the investment profits and repays the overseas loan when the LC is due.

Higher domestic capital cost spurs inventory

To prove their points, Professor Hsu and Professor Wu collected country-level data from China’s General Administration of Customs and Shanghai Futures Exchanges, such as monthly product-level metal import data for copper, aluminium, and zinc, as well as domestic and overseas lending rates, and currency exchange rates, from January 2010 to December 2017.

The analyses found a solid and positive correlation between the primary imported metals and the domestic and overseas interest rate spread (the differences in interest rates). The economic impact of the financial instrument role of inventory is more substantial than that of many macroeconomic factors that would drive inventory demand.

The researchers also obtained firm-level data from the balance sheets of over 2,000 companies operating in the manufacturing sector of the China A-Share market listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange. The data spans from January 2010 to June 2018. As expected, the results confirmed the positive relationship between firm-level inventory and interest spread rate.

As the world’s second-largest economy, China plays a significant role in metal production and consumption.

“When facing a higher interest rate spread, typically associated with a higher domestic capital cost, a firm may be more likely to take the strategic decision to overstock its inventory,” says Professor Hsu. “Traditional inventory theory, by contrast, holds that a higher capital cost should cause a firm to reduce its inventory.”

Furthermore, the study found that companies with greater borrowing capacity, indicated by higher liquidation value, larger size, and higher sales growth, are more likely to utilise inventory as a financial instrument to achieve financial gains.

Mitigating potential risks

Despite the abovementioned benefits, Professor Hsu highlights that the strategy is not risk-free. Importers who stockpile inventory to capitalise on higher returns may face excess products and increased demand unpredictability.

“Firms can mitigate these risks by selectively using imported inventory of goods with high value compared to their storage costs,” he says. “Additionally, firms can purchase futures contracts, when available, to hedge any risks arising from uncertainty in the price of the imported inventory.”

“Both factors can be seen at play for metal processing firms, which not only import metal commodities with a high ratio of price to storage costs, but also have access to metal commodities futures markets.”

As emerging economies integrate further into global supply chains, regulators will face growing difficulties in protecting their domestic financial markets from the impact of the global market through capital control measures. Nevertheless, Professor Hsu observes that China’s capital market risks remain limited as long as importing firms leverage their regular trade activities to capitalise on cheap overseas capital.

Export Quotas: How Should Companies Manage Production?

“Our research suggests a primary incentive for firms to conduct their import activities through Hong Kong,” he adds. “As both a major port and financial hub, Hong Kong is a natural staging ground for offering trade financing to Chinese importers that not just hedge their currency risk, but also generate financial returns arising from favourable currency market movements.”

Although the research results are based on China’s experience, they can have broader implications for other emerging economies that also impose tight capital controls. Similarly, the results can be generalised beyond the metal industries, as Professor Hsu has observed similar activities in industries such as textile, wood and paper, and electrical and electronics.

“The primary criterion is that the imported goods should be characterised by stable demands and relatively low inventory costs.”

The post When wealth grows on inventories first appeared on China Business Knowledge.

Export Quotas: How Should Companies Manage Production?

Putro — Thu, 21 Jul 2022 02:00:59 +0000

CUHK research finds that companies would profit more from stockpiling inventory even when sales is restricted by export quotas

By Jaymee Ng, Principal Writer, China Business Knowledge@CUHK

Around the world, protectionism is again on the rise. Countries, fearful of the “race to the bottom” – which refers to the idea that fully liberalised international markets would benefit lower cost countries and lead to a vicious cycle where everyone seeks to lower costs, are enacting trade barriers left and right. To protect sensitive industries from globalisation, countries often employ a range of tools in their economic arsenal, and this can range from tariffs and other trade barriers to highly restrictive export quotas that regulate the volume of trade between two countries.

Take for example, the U.S.-China trade war that started back in 2018 and which led to China restricting its exports of rare earths – a commodity which it holds a near-dominance on its supply and which is a critical component used in the manufacture of a wide range of high-tech products, from electric and hybrid cars, to computers, advanced ceramics and even sensitive military hardware such as stealth fighters. For companies that rely on exports, how much inventory should companies hold knowing that their sales may be restricted by quotas? A recent research study investigates the impact of export quotas on inventory, and shows that companies would benefit from producing more products than what the quota stipulates.

“For companies which sell their products to overseas markets, trade policies such as export quotas can and do drive critical operational decisions.”

Prof. Gong Xiting

The research study Multiseason Production Planning under Export Quotas was conducted by Gong Xiting, Associate Professor in the Department of Decision Sciences and Managerial Economics at The Chinese University of Hong Kong (CUHK) Business School, in collaboration with former PhD student Chen Tianxiao, Prof. Li Qing at the Hong Kong University of Science and Technology and Prof. Xu He at Huazhong University of Science and Technology.

“For companies which sell their products to overseas markets, trade policies such as export quotas can and do drive critical operational decisions, from where they locate their manufacturing base, to how they source and distribute their products and manage inventory,” says Prof. Gong. “Quotas decouple inventory from sales. That is, a company can only sell as much as the quota it is assigned permits, and this changes how they manage their production and inventory. The key question for these firms is how much they should produce given the presence of these quotas which limit their ability to generate profit .”

Optimal Inventory Level

The U.S.-China trade war in 2018 led to China reducing its export quotas on rare earths, which is a critical component used in the manufacture of sensitive military hardware such as stealth fighters.

To answer this question, the researchers developed a theoretical model to calculate the optimal inventory level for companies that produce and sell products restricted by export quotas. Using this model, they show that companies indeed benefit from producing and holding more stock than the allocated quota for export. Even though this excess stock cannot be sold in the current interval, it will allow the company to generate sales in future periods when new quotas are granted, especially if the company does not possess the capacity to produce products quickly enough to cope with a sudden rise in demand.

The researchers also looked into the influence of production capacity and seasonal demand on companies’ inventory strategy. After completing various mathematical calculations, the research team found that the benefit of stockpiling products is at the highest level when the company has a moderate level of capacity, the demand is seasonal and the peak demand is generated at the beginning of an interval when new export quotas are allocated.

“Our assessments show that the downside of limiting production only to current quota can be substantial. But of course, not every company can afford to hold a large inventory and stockpiling might not be the best solution for everyone,” Prof. Gong says.

Production Capacity and Seasonal Demand

The researchers note that whether a company is able to build a stockpile of its products depends on its operational production capacity. They explain that when the production capacity of a company is small, then it would not be able to produce enough products to stockpile inventory to a meaningful level. On the other hand, there is no need for companies with a large production capacity to stockpile inventory as they have the ability to easily produce additional products when the need arises. Therefore, it is companies with a moderate level of production capacity that would benefit the most from stockpiling inventory.

The second factor that affects a company’s decision to stockpile is seasonal demand. Seasonal demand refers to periods with predictable demand patterns due to re-occurring events, such as the Christmas holidays, Valentine’s Day or Easter. For example, the demand for turkey usually increases significantly during Christmas. The researchers compared two types of seasonal demand: When the peak demand arrives in the last period of a sales season and when the peak demand emerges in the beginning of a given season when new export quotas are allocated.

Whether a company is able to build a stockpile of its products depends on its operational production capacity, the study’s researchers noted.

The study results show that when the peak demand and the allocation of large quantity of export quotas coincide in the initial period of a given season, stockpiling becomes more important. This is because the company will be able to sell to foreign customers in a time of high demand by using the export quotas available in this period. In subsequent periods when demand is low, they can then switch focus to stockpiling inventory in anticipation of meeting the next round of quota allocation and peak demand.

On the other hand, companies are less likely to benefit from stockpiling if demand for its products peak at the end of a given season. Simply put, there is no incentive for them to stockpile goods because they would not be able to take advantage of the high demand at the end of the season if all of their export quotas had already been used up for the period.

Benefits for Export Firms and Policy Makers

The researchers note that not only will the theoretical model developed in the study be useful for companies as a decision tool when planning production and inventory, but it could also benefit policy makers when allocating export quotas or negotiating trade terms with trading partners. “We show that by maintaining a consistent and predictable pattern of quota allocation, it produces quantifiable operational value for firms that rely on exports as their primary source of revenue. The theoretical model that we developed could help policymakers to make an informed and data-driven export policy,” he says.

Prof. Gong and his collaborators note that results of the study could also be applied to settings where sales are limited intentionally, such as the regulation of the tobacco industry. In many countries, governments impose quotas on the amount of tobacco products they are legally allowed to sell during a given season.

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The researchers also suggest that the model can be further explored in several directions, for example, by extending it to allow for unused export quota in one season to be carried over to the next, or to consider what would happen if companies were permitted to sell their products to both a domestic market with no quota restrictions and to a foreign market.

“Given the importance of international trade, we believe that inventory and production management in companies specialising in exports is a rich area that offers researchers ample opportunities to delve further. We hope our study will stimulate more interest,” Prof. Gong says.

The post Export Quotas: How Should Companies Manage Production? first appeared on China Business Knowledge.