The Financing Role of Inventory: 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 macro and micro 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’s country-level metal commodity imports and firm-level inventory from metal processing industries (with metal commodities as primary inputs), 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 show that levels of imported metal commodities are 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 increased short- term borrowing. In addition, firms with higher borrowing capacity, larger size, or higher sales growth are more active in using inventory as an instrument to seek higher financial gains. We also utilize a unique regulatory policy shock as a natural experiment to establish causality in our empirical analysis.