Something in Europe’s highly interconnected supply chain has changed, and it is not just about border control. In fact, while European leaders discuss the future of the Schengen agreement for free movement of people and goods, a less prominent headline but remarkable adjustment in European business planning is taking place in corporate inventory management. Persistent uncertainty and some big losing bets have led firms to reduce inventories and more aggressively adjust production according to expectations about future inventory levels and consumer demand. This has caused businesses to become more hesitant to build up their inventories.
Analysis of inventory management trends over the past 25 years confirms that businesses are not making incremental investments to improve capacity. The euro is weak, and Europe is experiencing a nascent economic recovery, boosting current demand for industrial exports. However, exports and inventories data, typically important signposts in the recovery of many European economies, have become more volatile, obscuring the business decision-making process. Companies may need to make their supply chain management and production processes more flexible as a result.
A post-crisis shift in inventory management
Firm inventory decisions are closely tied to expectations. Businesses hold more inventories when they are confident about future demand. They draw down their stocks when they are unsure that they will be able to sell what they have built up, or when demand temporarily exceeds production. Inventories are therefore highly pro-cyclical, and changes in aggregate level can have a powerful and volatile effect on GDP calculations. For example, among Eastern European EU countries, inventory changes can account for up to 40 to 80 percent of fluctuations in GDP.
The stakes for getting inventories right are high. Holding inventory is expensive, especially for Central European producers of high tech machinery that becomes obsolete quickly. At the same time, holding too little inventory can result in stock losses if customer demand goes unmet. Since the crisis, firms have become more cautious about these costs, adjusting production plans more aggressively in response to expectations of inventory buildup or slowdown. However, since companies have also reduced their inventory stocks since the crisis, this change substantially increases overall inventory level volatility. With thinner margins, firms must react more dramatically to unexpected demand changes or miss out on upside opportunity.
This inventory volatility is likely the result of two post-crisis developments. First, firms may simply be more cautious about the strength of future demand. Second, the change may also be a symptom of fear about external funding constraints. When cash is short and credit is tight, selling inventories or deferring purchases is a quick way to fund operations. Because this effect is less pronounced in the UK than in the eurozone, it suggests that eurozone funding constraints are a key contributor. After all, this issue of tight credit is one that FSG has highlighted as key contributor to sustained low economic growth.
Germany: a case study
Germany’s economy is heavily industrial and export-oriented, making it highly reliant on a well-oiled supply chain. It is therefore an ideal case study to evaluate the consequences of this phenomenon of changing inventory management practices and business hesitance to invest in additional capacity.
German businesses went to great lengths to streamline their inventory management during the 2000s and experienced relatively stable cumulative inventory levels through 2007. However, inventory level volatility began to grow in 2008 before settling at a level approximately 54 percent higher in 2009, and increasing again from 2014. In 2014, quarterly changes in inventory levels could be as large as four to six percent of German GDP. As a result of these changes, in Q3 2015 cumulative inventories were 46.5 percent below their 15-year average, an astonishing country-wide drawdown.
Explaining the drawdown: Is pessimism justified?
The cause of this massive drawdown is not certain, but business pessimism appears to be the best explanation, in line with the aforementioned EC conclusions. Low confidence conditions firms’ response to changes in aggregate demand, causing them to be overly cautious despite improving consumption and exports. Firms have not increased production to meet rising consumer spending, likely because of residual worry about getting burned again by unjustified optimism.
While growth in exports is a sign of economic strength and should therefore improve confidence, it can be rejected as an explanation of the inventory drawdown. Real growth in exports resumed at the end of 2013, but the relative volume of imports and exports has been constant. This suggests that firms are importing what they need to produce, and neither acquiring excess intermediate inputs nor selling out of inventory stocks. It is thus unclear how exports could be contributing to the drawdown.
Instead, a rise in domestic consumption unmet by a corresponding increase in production matches both data and theory. While consumption was slow to recover from the crisis, figures from the end of 2014 and early 2015 look promising. Retail sales growth has been strong, lending to households is picking up, and a large influx of migrants should support demand for consumer durables. Consumer goods producers have accordingly demonstrated lower inventory level volatility among relative to other businesses. Since this higher level of consumer spending is line with historical trend, it is the failure of businesses to react that is the aberration.
‘Fool me twice’ – the consequences of pessimism about optimism
The twin peaks of inventory build up on either side of 2009 taught firms a powerful lesson. Before the crisis, the trend of production growth was stronger than the trend of consumption growth, and inventories piled up. Despite the huge apparent drawdown on inventories during the crisis, cumulative inventories only fell 3.9 percent below their 2001 level. Afterwards, producers were overly optimistic about the pace of recovery and repeated an analogous mistake, rebuilding stocks too quickly.
Having survived the crisis only to be burdened once again with substantial excess inventory stock, firms have been slow to acknowledge that consumer spending is growing again. Aggregate inventory stocks plummeted because firms preferred to wait and see about future demand before rebuilding inventories. After all, with inflation flat or even negative, there is little direct financial opportunity cost to hesitation.
However, there are risks to an overly-pessimistic approach to inventories. First, there is likely a limit to how much further firms can cut inventories before they start to run into major supply chain inefficiencies. “Just in time” production requires the elimination of waste, but unwillingness to hold inventories may reduce economies of scale in manufacturing and cause a costly reliance on rushed production or distribution. If this increased planning uncertainty is passed on to suppliers and customers, then business relationships may become strained.
A second worry is that failing to respond to viable demand risks leaving money on the table. With inventories so far down, there may be substantial opportunity for select firms to scale back up. For example, if competitors are slow to respond to a viable improvement in consumer demand, companies may be able to win market share if their ability to shift or scale production to meet the demand is greater. When conditions are volatile, companies can create value by being flexible.
An upcoming blog post will directly evaluate how this reality plays out across the Western European supply chain, showing the significant implications of a change in supply chain management for Central and Eastern European countries.
Research, analysis, and writing for this blog post was led by FSG’s research intern, Edward Moe. This article relied heavily upon research presented in the European Commission quarterly reports on the euro area.
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