RDP 2013-13: Inventory Investment in Australia and the Global Financial Crisis 2. Inventory Investment and Short-term Credit Conditions

Under perfect capital markets, credit conditions only affect inventory investment through unexpected changes in short-term interest rates to the extent that they represent changes in the opportunity cost of internal finance. But early empirical research, which typically relied on time-series evidence, generally found that real short-term interest rates had no influence on inventory investment (Maccini, Moore and Schaller 2004).^[2]

Advances in corporate finance theory, as well as the development of microeconomic (firm-level) datasets, helped to reconcile this puzzle. Theoretical research showed that capital market imperfections, such as transaction costs and asymmetric information, could cause external finance to be more costly than internal finance for firms. Moreover, the cost of external finance typically varies (inversely) with the health of borrowers' balance sheets. If some firms are credit constrained in the sense that they cannot obtain external finance, or can obtain it only by paying a premium over the opportunity cost of internal funds, then their investment can be affected by financial factors, such as their holdings of liquid assets.

With imperfect capital markets, all types of investment should be affected by credit constraints, but inventories are likely to be particularly sensitive (Carpenter et al 1994). First, inventory investment involves low adjustment costs so businesses can respond quickly to adverse financing shocks by liquidating inventories. Second, inventory investment is largely reversible, as firms can dramatically cut their inventory stocks, unlike other investments, such as research and development and fixed capital (Carpenter et al 1998). Third, inventory investment is generally financed through short-term debt supplied by banks and trade creditors, rather than long-term debt or equity, so unexpected external finance shocks can have a relatively large impact on the accumulation of stocks. If credit supply shocks directly affect the real economy, this should be most readily observed in inventory investment (Lown and Morgan 2006). There is now extensive empirical research at the firm-level suggesting that credit constraints do affect inventory investment (e.g. Carpenter et al 1994, 1998; Gertler and Gilchrist 1994; Kashyap et al 1994; Guariglia 1999; Guariglia and Mateut 2006).

Footnote

There is recent aggregate evidence that the risk premium component of interest rates is negatively related to inventory investment (Jones and Tuzel 2013). [2]