The Other Credit Crunch
Much has been made of the apparent lack of demand for credit as well as apparent supply (especially well-collateralized and credit-worthy credit) during a period when the banks have been mouth-to-a-fire-hose gorged on money. Small businesses, as UBS notes, have been at the center of this debate - as the engine of the economy, politicians have been vociferous in the face of banks ignoring their suggestions to lend. This initial credit crunch, however, has led to a structural change among small businesses which may have a much larger slowing-impact on OECD growth than is currently understood. Small businesses horded cash and reduced their reliance on bank loans after the crisis as the fear of the credit crunch remains front-and-center (and therefore crushed a key transmission mechanism of monetary policy). This drop in demand is driven by the hidden credit crunch - a structural shift to more just-in-time inventory management regime. This in turn reduces the inventory:sales ratio (which is exactly what we have seen in an unusual divergence from large business and appearing like a structural decline). The worrying aspect of this, and indeed the other credit crunch is that the inventory management regime-change among small businesses exaggerate anaemic growth since restocking has traditionally helped to drive economic growth above trend in a recovery phase. As UBS' Paul Donovan concludes, "the traditional concept of inventory restocking may be a great deal more lacklustre in the current environment."
UBS: The inventory revolution
The focus of politicians and markets in the last few years has been directed towards the pattern of the credit crunch through bank lending. Banks have been urged to lend more (indeed, ordered to lend more in some cases). In particular, there has been a concern about the credit offered to small business.
There is evidence that some of the pressure on banks may be misdirected, and that the economic problem has been a potent but hidden credit crunch rather than the more visible availability of bank credit. The hidden credit crunch has in turn led to a structural shift in small businesses inventory management.
The hidden credit crunch
Small businesses do not rely on bank credit as much as is thought. The popular perception is that bank lending dominates small business credit — and for investment in equipment and machinery there is certainly some validity to that assumption (although loans from family also play a role). However, the most important form of credit by volume is the credit that helps to fund working capital — intercompany credit. This is mainly the credit that arises from the invoicing process; companies do not have to pay for their goods immediately, but (for a certain value of goods at least) have time in which to settle the account with their supplier.
With the onset of the financial credit crunch in 2008, large and small companies looked to maximise the liquidity that they had. The increase in cash on balance sheet in the corporate sector overall has been remarkable. ... Other OECD economies also saw corporate cash levels increasing.
This increase in cash at least partially reflects a decline in the availability of credit in various forms, including intercompany credit. The increase in cash balances also reflects the successful reduction in the volume of credit offered by non financial businesses — less credit offered to clients means more cash on the balance sheet, at least near term...
The inventory reaction
Confronted by reduced intercompany credit, the evidence is that small businesses changed their inventory management techniques, in a way that had not been tried before — at least, not for this size of business. Small businesses moved to just in time inventory management.
This first chart shows the reaction. The US NFIB survey includes a variable for small businesses' desire to increase inventory. Meanwhile the US ISM survey includes coverage of whether surveyed companies (generally larger companies) believe their customers (including smaller companies) need to increase inventory holdings. For most of history these two lines are relatively closely correlated, as one would expect. Large companies predict their customers' need to restock, and small companies agree that they do need to restock. But the onset of the financial crisis and an inter company credit crunch changes this pattern.
From 2009 onwards large businesses repeatedly report that their customers need to increase their inventory levels. Small businesses, meanwhile, report that their inventory levels are too high and that they have no plans to increase inventory. This divergence is extremely unusual, and seemingly reflects large businesses judging their customers' inventories by the standards of the past, without accounting for a shift in behaviour which large business itself has brought about. After all, why would a small company hold 45 days inventory if only offered 30 days intercompany credit from its suppliers with which to fund that inventory position?
What is different about this credit crisis is the fact that small businesses not only have the motive to pursue just in time inventory management, they also have the ability to manage inventory in a just in time fashion. Software, technology and on line ordering has advanced to a stage where essentially any business can pursue a just in time inventory management process. The infrastructure was simply not available in the past, even as recently as the 2001 economic downturn.
If small businesses are more likely to be efficient in their management of inventory, then inventory:sales ratios should undergo a structural decline. That, indeed, seems to be what has happened.
Inventory:sales ratios have reached record lows in the retail sector. With small businesses accounting for the majority of inventory holdings (circa 70% in most advanced economies), this improved efficiency in inventory management suggests that the traditional concept of inventory restocking may be a great deal more lacklustre in the current environment. Inventory restocking has traditionally helped to drive economic growth above trend in the recovery phase — and so the inventory revolution may help to explain the somewhat anaemic nature of the economic recovery to date in the OECD economies.