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. In this paper, we provide evidence that inventory can be used as a financial instrument to take advantage of arbitrage opportunities in financial markets with limited capital mobility. We develop a model based on prevalent industry practices in China to demonstrate how a firm can utilize the inventory of an imported product (typically a commodity) to carry lower-cost capital into a country with strict capital controls, and thus gain higher financial returns. We first use country-level data in China to show that the inventory levels of commodities are positively associated with the expected returns from financial arbitrage. We then utilize firm-level data from China’s metal processing industries (with metal commodities as their primary inputs) to empirically test several model predictions. 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 short-term borrowing capacity are more active in using inventory as a financial instrument to seek higher yields.