When wealth grows on inventories

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.

“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.

“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.

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“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.”