Which of the following tend to have higher levels of inventory investment?

Inventories are the most volatile component of a country's gross domestic product (GDP). Specifically, even though it constitutes less than 1% of GDP in advanced economies, aggregate inventory investment is 20 times more volatile than GDP (Dasgupta et al., 2019). Similarly, in the Chinese context, China's annual inventory investment only accounted for 3.5% of GDP over the period 1992–2010, but its fluctuations explained as much as 20% of the total fluctuations in GDP (Long et al., 2020). As a result, inventory investment plays a major role in business cycle fluctuations both in western countries and in China (Blinder and Maccini, 1991; Caglayan et al., 2012; Nikolov, 2013; Maccini et al., 2015; Lin and Liu, 2016) and is frequently considered as a leading indicator for the overall performance of the economy (Kim, 2020; Trading Economics, 2020).2

A number of studies investigate the role of financial variables such as, for example, the debt-to-assets ratio or cash flow, in explaining corporate inventory investment. They find that inventory investment is particularly sensitive to changes in financial variables, especially if compared to fixed investment.3 At the same time, a growing literature shows that financial development significantly affects firms' decisions on how to finance their activities. In particular, well-developed financial markets reduce the costs of external finance, making it easier for firms to finance their activities using bank loans or issuing shares (Rajan and Zingales, 1998; Fisman and Love, 2003; Ge and Qiu, 2007). By contrast, informal and more expensive sources of finance such as trade credit have been found to be prevalent in less developed financial markets and/or for firms facing tighter financial constraints (Fisman and Love, 2003; Guariglia and Mateut, 2006; Mateut et al., 2006; Ge and Qiu, 2007; Cull et al., 2009).4,5

In this paper, we examine the role of interest-bearing loans and trade credit in financing Chinese firms' inventory investment, differentiating firms on the basis of the financial development characterizing the cities in which they operate.6 Our specific aim is to understand how financial development affects firms' choice of loans and trade credit in financing inventory investment. In other words, we aim at testing the indirect effect of financial development on firms' inventory investment, which occurs by changing the mix between interest-bearing loans and trade credit used to finance inventory investment.

The Chinese setting provides an ideal laboratory to address these issues for four reasons. First, China has been characterized by rapid growth despite a malfunctioning financial system (Allen et al., 2005). It is therefore interesting to understand how Chinese firms finance themselves. Second, in China, changes in inventories are considered to be a leading indicator for the overall performance of the economy (Trading Economics, 2020). Third, China's financial development is strongly unbalanced.7 As a result, firms in cities with different levels of financial development may experience different costs of financing. Fourth, in 2007, China introduced a property rights reform, which can be seen as an exogenous regulation shock and provides a clean identification of the causal effect of financial development on the choice of financing of inventory investment.

The National Bureau of Statistics (NBS) of China provides us with a sizeable dataset, which enables us to test the extent to which Chinese manufacturing firms' inventory investment is affected by the availability of formal and informal credit. We then construct a unique dataset of city-level financial development indicators and merge it with our firm-level dataset. This enables us to investigate the extent to which firms operating in cities characterized by different levels of financial development use different mixes of interest-bearing loans and trade credit to finance their inventory investment.8 Our final dataset contains 224,604 mostly unlisted firms operating in 287 cities covering the entire Chinese territory over the period 2004–2009.9

We observe that Chinese firms make use of both interest-bearing loans and trade credit to finance their investment in inventories. Furthermore, we find that financial development encourages firms to change the way they finance their inventory investment away from trade credit and towards loans. These effects are more pronounced after the 2007 property rights reform, as well as for privately-owned firms, small firms, firms with no political connections, and firms located in coastal regions. Given that trade credit is typically more expensive than bank credit (Petersen and Rajan, 1997; Nilsen, 2002), by further enhancing financial development throughout the country, Chinese authorities could ensure that firms gain access to cheaper formal finance, which would enhance their inventory investment, and ultimately promote economic growth.

From a general viewpoint, our work brings together the literature on the financing of corporate activities and the literature on financial development and growth. Specifically, by focusing on the role of interest-bearing loans and trade credit in financing inventory investment, we contribute to the literature on how firms' real activities are financed. We build on this literature by looking, for the first time, at how financial development affects the mix between interest-bearing loans and trade credit used by firms to finance their inventory investment.

Furthermore, as inventory investment contributes significantly to economic growth in China,10 we also add to the literature on financial development and economic growth, not by seeing how financial development directly contributes to growth (which has been done many times in the past), but by stressing, for the first time, its indirect effect on the mix between trade credit and interest-bearing loans that firms use to finance their inventory investment (which is an important determinant of economic growth).

From a more specific viewpoint, our paper builds on Carpenter et al., 1994, Carpenter et al., 1998 and Guariglia and Mateut (2006), who look at the role of financial variables in determining inventory investment in the US and the UK, respectively, by analyzing, for the first time, the role played by interest-bearing loans and trade credit in explaining Chinese firms' inventory investment, differentiating firms according to ownership, financial conditions, and location. Second, we extend Fisman and Love's (2003) country-industry level analysis by investigating, for the first time, the extent to which city-level financial development influences firms' choice of financing within one country. Third, we provide further evidence on the substitution hypothesis, which posits that firms tend to increase their use of trade credit when accessing bank credit becomes more difficult (Meltzer, 1960; Petersen and Rajan, 1997; Burkart and Ellingsen, 2004; Chen et al., 2019). Finally, our study provides microeconomic evidence on the debate surrounding the finance-growth nexus in China (e.g. Allen et al., 2005; Guariglia and Poncet, 2008; Zhang et al., 2012), focusing on inventory investment, which significantly contributes to GDP fluctuations (Long et al., 2020).

The remainder of the paper is organized as follows. Section 2 provides some economic background. We develop our hypotheses in Section 3. Section 4 presents the dataset and summary statistics. Section 5 describes the specification of our models and the estimation methodology. In Section 6, we discuss our main results and present a variety of robustness tests. Section 7 focuses on the effects of financing constraints. Section 8 discusses the role of the 2007 property rights reform, and Section 9 concludes.

Economic background

China has been considered as a counterexample to the traditional view in the finance-growth literature according to which financial development facilitates economic growth (Boyreau-Debray, 2003; Allen et al., 2005; World Bank, 2006; Guariglia and Poncet, 2008). Despite a poorly developed financial system, it has in fact one of the fastest-growing economies in the world (Allen et al., 2005).

The financial system in China is mainly bank-based.11

Direct effects of interest-bearing loans, trade credit, and financial development on inventory investment

We first hypothesize a positive association between both interest-bearing loans and trade credit and inventory investment. This can be explained considering that both trade credit and loans are sources of external finance, which can be used to fund the investment in inventories (Petersen and Rajan, 1997; Guariglia and Mateut, 2006; Restrepo et al., 2019). Furthermore, we hypothesize that a higher level of financial development is also positively associated with inventory investment. This can be

Data

We utilize firm-level data drawn from the annual accounting reports of industrial firms conducted by the National Bureau of Statistics (NBS) of China from 2004 to 2009. The NBS data contains accounting variables and firm-specific information for enterprises in the manufacturing and mining sectors with annual sales above 5 million RMB (“above-scale” industrial firms). These firms come from 31 provincial-level administrative units, which can be further decomposed into 287 prefecture-level cities

Baseline specification

Our baseline specification is an extension of Lovell's (1961) stock adjustment model, which has been widely used in the literature to explain the dynamic adjustment of inventory investment (Kashyap et al., 1994; Guariglia, 1999; Benito, 2005; Guariglia and Mateut, 2006).29

Main results

We estimate Eqs. (1), (2) for the whole sample using the fixed-effects estimator, which enables us to take into account the Vj component of the error term (i.e. unobserved firm-specific heterogeneity). The results are shown in Table 3. Column 1 reports the estimation results of the baseline model (Eq. (1)). The coefficients associated with interest-bearing loans and trade credit in column 1 are both positive and statistically significant at the 1% level, which indicates that, in line with

Taking financing constraints into consideration

This section is aimed at testing Hypothesis 3, according to which financial development has a stronger impact on the choice of financing of inventory investment for firms more likely to face financing constraints. In Section 7.1, we differentiate firms according to ownership and, in line with Poncet et al. (2010) and Guariglia et al. (2011), consider private firms as most likely to face financing constraints. Then, in Section 7.2, we classify firms on the basis of alternative criteria which

The role of the 2007 property rights reform

In 6.2.2.1 Using a fixed-effect instrumental variable (IV) estimator, 6.2.2.2 Using the system generalized method of moments (GMM) estimator, we used IV fixed-effects and GMM models to account for the possible endogeneity of city-level financial development. However, our baseline regressions could still suffer from endogeneity problems. An alternative strategy to deal with this issue would be to exploit some exogenous regulation shock in the Chinese financial market. To this end, we have

Conclusion

Using a panel of 224,604 Chinese firms operating in 287 cities over the period 2004–2009, together with a set of unique city-level financial development data, this paper presents evidence on how financial development affects the use of different sources of financing, namely interest-bearing loans and trade credit, to finance corporate inventory investment.

Our results suggest that both interest-bearing loans and trade credit play a significant role in financing inventory investment. We also find

Funding

This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

Declaration of Competing Interest

None.

Acknowledgements

We thank William Megginson (the editor), two anonymous referees, and Simona Mateut, for providing valuable suggestions and constructive comments. We are also grateful to participants at the 2016 Birmingham-Sheffield Research Workshop (Birmingham), the 2016 International Finance and Banking Society Conference (Barcelona), the 2017 Royal Economic Society Annual Conference (Bristol), the 2017 Nanqiang Youth Scholar Forum (Xiamen), and the 2017 European Financial Management Association Conference

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