Inventory Management with Trade Policy Uncertainty

• Published date: 01 September 2022
• Author: Xiaotao Zhao,Xiaoping Chen
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/cwe.12440

©2022 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 128–153, Vol. 30, No. 5, 2022

128

Inventory Management with Trade Policy Uncertainty

Xiaotao Zhao, Xiaoping Chen*

Abstract

This paper develops a theoretical model to describe how exporting firms manage

their inventory stocks in response to an exogenous trade policy uncertainty shock.

Using fi rm-level data from China Industrial Enterprise Database and China Customs

Database on inventory and exports over the period around China’s WTO accession,

we show that a reduction in trade policy uncertainty signifi cantly increased exporting

firms’ inventory holdings. The result was robust to various robustness checks.

This effect was found to be stronger for private and foreign firms than state-owned

enterprises and mainly driven by fi rms from the coastal region. We also found that the

reduction in trade policy uncertainty increased the frequency and the average volume

of export transactions, and that this was the mechanism behind the eff ect. This paper

helps to understand exporting firms’ optimal inventory problem arising from trade-

policy uncertainty and shocks.

Keywords: difference-in-differences, inventory management, trade frequency, trade

policy uncertainty

JEL codes: F14, G31

I. Introduction

Inventory management is one of the key operational decisions that firms have to

make. There are many reasons for firms to maintain a certain level of inventory. For

example, the lumpiness of consumer demand requires positive inventory stock so that

the customers can be served with enough products in a timely fashion. Delivery lags in

sales and fi xed costs (increasing return to scale) of shipment or transactions both suggest

that a certain level of inventory is required for firms to maximize profit. In an open

economy setting, inventory may play an even larger role. First, foreign market demand

*Xiaotao Zhao, Research Assistant, Institute of Applied Economics, Shanghai Academy of Social Sciences,

China. Email: taotao19900820@126.com; Xiaoping Chen (corresponding author), Associate Professor, School

of Economics and Management, Harbin Institute of Technology, Shenzhen, China. Email: chenxiaoping@hit.

edu.cn. The authors thank seminar and conference participants at Kobe University, Zhejiang University, East

Asia Institute, and 2019 Asia-Pacifi c Trade Seminar, for their valuable comments and suggestions.

©2022 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Inventory Management with Trade Policy Uncertainty 129

may be lumpier and more uncertain than domestic market. Second, the delivery lag for

international orders is likely to be longer than that for domestic ones and the fi xed cost

of export shipment is usually larger for international trade than for domestic sales. In

the data for Chinese manufacturing fi rms, we fi nd that exporting fi rms have signifi cantly

higher inventory-sales ratios than nonexporting fi rms.1

In a recent seminal work, Alessandria et al. (2010a) have documented that micro-

level trade flows are lumpy and infrequent. This inventory management problem of

importer facing shipping delays, the economics of scale in transacting, and demand

uncertainty quantifi es a tariff equivalent of inventory carrying cost of 20 percent, nearly

six times larger than the physical costs of trade. As estimated based on the Census

of Retail Trade and Annual Survey of Retail Trade, in the US the overall inventory

costs on average account for 6 percent of sales. Alessandria et al. (2010a) applied

their model to investigate the import fl ows and the price of imported goods after large

devaluation shocks and showed that the optimal inventory holdings were lower, and

that importers reduced their inventories by not importing for a while and by reducing

retail markups to sell existing inventories more rapidly. Their work highlights the

role of inventory in the dynamics of imports and prices. Yet, empirical investigations

on inventory management for other countries are still limited, especially from the

exporters’ perspective. For various reasons, such as poor logistics and limited fi nance

for inventory, the cost of inventory holding may be even larger for developing countries.

As a result, this paper investigates exporters’ inventory management in China, a

large developing country. As highlighted by Alessandria et al. (2010a) and Khan and

Khederlarian (2021), the inventory holding cost is not negligible for productivity and

markup estimation. Alessandria et al. (2010a) also investigated inventory for importers

facing large devaluation shocks. We study the inventory for exporters facing a trade

policy uncertainty shock around China’s WTO accession. Besides the importance of

inventory for exporters, another benefit of focusing on exporting firms’ inventory is

that the industrial heterogeneity in trade policy uncertainty and fi rm-level heterogeneity

in exporting destinations provide an ideal setting to identify the causes of firm-level

inventory adjustment.

We use fi rm-level data on Chinese exporters’ inventory and exports to the US and

other countries over the period around China’s WTO accession at the end of 2001.

China has opened up to international trade since the late 1970s and signifi cant policy

changes toward trade liberalization were made throughout the 1980s and 1990s. Before

1We establish this fact more rigorously in another paper – see Chen and Zhao (2020) for more on this pattern.

We do not investigate the reasons behind this fi nding in the present paper. Instead, we use it as a motivation

for our focus on exporters’ inventory management.