RDP 2013-13: Inventory Investment in Australia and the Global Financial Crisis 1. Introduction

A sharp drop in inventory investment was the main contributor to the decline in real GDP in Australia in the December quarter of 2008. Inventory investment consistently fell in each of the following seven quarters, directly contributing to the slowdown in the Australian economy at that time. The size of the fall in inventory investment following the onset of the global financial crisis has been only superseded over the past 40 years by the early 1980s recession (Figure 1).^[1]

There are at least two plausible explanations for this particularly sharp decline in inventories. First, firms may have expected a large fall in sales. A notable feature of the financial crisis period was a significant fall in demand for consumer durables in Australia and other advanced economies (Black and Cusbert 2010). If firms expected demand for their goods and services to fall, this would have encouraged them to meet demand by running down existing stocks rather than investing in new stocks. Second, firms may have been less willing (or less able) to invest in inventories as the cost of obtaining credit increased and its availability decreased.

The aim of this paper is to identify the extent to which the large decline in inventory investment in 2008/09 can be traced to a tightening in credit conditions (the ‘credit constraints hypothesis’) as opposed to a fall in actual, or expected, demand (the ‘demand hypothesis’).

An important challenge in attributing the fall in inventories to tighter credit conditions is to separately identify a fall in credit supply from a fall in credit demand (Peek, Rosengren and Tootell 2003). I address this identification problem in an experimental design framework. In particular, I identify the relationship between inventory investment and credit conditions by exploiting variation in the maturity structure of the debt owed by listed Australian companies in the period before the global financial crisis.

More specifically, I separate listed companies into two groups – those companies that were ‘unlucky’ in that they had a large share of outstanding debt falling due at the peak of the crisis in late 2008 and those companies that were ‘lucky’ in that most of their debt fell due at some other (non-crisis) time. The assumption is that the unlucky firms would be forced either to repay or refinance much of their debt at a time when lenders were most concerned about credit and liquidity risk, and hence were looking to scale back the supply of credit. In other words, the unlucky firms would have been more constrained by the supply of credit. If the unlucky (constrained) firms reduced their inventory investment by more than the lucky (unconstrained) firms during the crisis, then, all other things being equal, this would provide evidence that credit conditions significantly affected inventory investment. A similar experimental design is constructed by Almeida et al (2009) to identify the effect of debt maturity on corporate investment in the United States.

The contribution of this paper is to link the sharp decline in inventory investment in Australia to the tightening of credit conditions in 2008/09. There is extensive evidence linking the cyclical behaviour of inventories to changes in credit conditions (e.g. Carpenter, Fazzari and Petersen 1994, 1998; Gertler and Gilchrist 1994; Kashyap, Lamont and Stein 1994; Tsoukalas 2006). But, to my knowledge, there has been no research linking the fall in inventory investment in 2008/09 to tighter credit conditions. This is despite evidence that an adverse credit supply shock and a sharp fall in inventories occurred simultaneously in many advanced economies during the crisis (Alessandria, Kaboski and Midrigan 2010). Jacobs and Rayner (2012) identify a key role for a negative credit supply shock in the 2008/09 downturn in Australia. This paper builds on their research by investigating whether the effect of such a credit supply shock can be traced to an inventory investment channel. To my knowledge, this is the first paper to examine the inventory cycle in Australia since Flood and Lowe (1993).

I find that the companies that were due to repay a relatively large share of debt in 2008/09 reduced their investment in inventories by significantly more than companies that were due to repay their debt at some other time. Furthermore, I show that the effect of debt maturity on inventories is only significant during the crisis period. However, I also find that the type of maturing debt matters; firms that had a relatively large share of short-term revolving credit due in 2008/09 were significantly more likely to reduce inventory investment. In contrast, firms that had a relatively large share of fixed-term debt maturing in 2008/09 did not necessarily reduce inventory investment. This raises the possibility that the link between debt maturity and inventory investment is not causal. Instead, less creditworthy firms may have drawn down more intensely on their existing credit facilities (leading to relatively high short-term debt) and reduced their inventories to free up liquidity. In this case, the maturity structure of the firms' debt would be a response to, rather than a cause of, tighter credit constraints.

A case study of the domestic motor vehicle industry also suggests that the withdrawal of two large international finance companies had an adverse effect on credit supply and, subsequently, inventory investment in the motor vehicle industry.

On balance, the results are consistent with the hypothesis that a tightening in credit conditions caused a fall in inventory investment during the crisis. But I cannot rule out the possibility that declining demand for credit also contributed.

Footnote

The quality of the national accounts estimates of inventory investment is known to be relatively low. For instance, the Australian Bureau of Statistics (ABS) indicates in its Concepts, Sources and Methods (ABS 2012) that private non-farm inventory investment has a relatively ‘poor’ data quality rating. Related to this, inventory investment estimates are particularly prone to revision. The ABS' estimates of real inventory investment during the global financial crisis have generally been revised down over time. [1]