Inventory as a Financial Instrument: Evidence from China’s Metal Industries

Abstract

Classical inventory theory suggests that inventory plays a vital role in matching demand and supply. This paper provides both country-level and firm-level evidence that inventory can be used as a financial instrument to take advantage of arbitrage opportunities in financial markets with limited capital mobility. Using data from China customs’ metal imports and firm-level inventory from metal processing industries, we show that firms can utilize the inventory of an imported product to carry lower-cost capital into a country with strict capital controls and thus gain higher financial returns. Specifically, at the country level, we find that the level of imported metal commodities is positively associated with the expected returns from financial arbitrage. At the firm level, we find that a higher expected return from financial arbitrage will incentivize a firm to increase its inventory level through short-term borrowing. In addition, our evidence supports the notion that firms with higher liquidation value, larger size, and higher sales growth (i.e., firms with higher borrowing capacity) may be more active in using inventory as an instrument to seek higher financial gains. We also utilize a unique regulatory policy shock as a quasi-natural experiment to enhance the causality interpretation of our empirical findings.

Keywords: inventory, financial instrument, operations-finance interface, empirical research