Manufacturing firms in developing countries often hold surprisingly large stocks of inputs compared to similar firms in the developed world. In new research published in the latest Economic Journal, Marcel Fafchamps, Jan Willem Gunning and Remco Oostendorp show that this fact stems from the higher risks these firms face compared to their developed-world counterparts. Unreliable sources of supply force manufacturers to hold large inventories of inputs, tying up funds that could have been used for investment. This implies that the risky environment in which firms have to operate in is costly in terms of economic growth.
The research uses survey data for 200 manufacturing firms in Zimbabwe. These data include detailed information on the pervasive risks that firms face: inputs not arriving on time, delays in payments, large changes in demand from one year to another, etc.
Analysing these data, Gunning and his colleagues find strong evidence that the risk of delayed deliveries and payments explains much of the inventory and financial behaviour of manufacturers. Holding large inventories of inputs offer firms insurance against the risk that late deliveries will disrupt their production process. Inventories reflect unreliable input supply whereas large unused overdraft limits reflect the risk of payment delays.
The researchers argue that economic liberalisation (which Zimbabwe undertook in the early 1990s but later reversed) reduces the risks firms face by strengthening competition and improving infrastructure. Liberalisation thereby removes the need for holding large stocks. In Zimbabwe, this was important: manufacturing firms reported drastic reductions in inventories when supplies became more reliable.
The study also shows that firms deal with changes in demand by maintaining excess capacity so that they have the flexibility to adjust to these changes. Hence, the day-to-day risks of delays in payments and deliveries induce large stocks while the year-to-year market risk is reflected in low capacity utilisation.
This is important because although firms'' response to their risky environment is efficient, it is costly in terms of forgone growth. Rather than investing in inventories or in stand-by capacity, firms could have invested in expansion. In Zimbabwe, managers reported that they drastically reduced stocks of inputs when the economic reforms of the early 1990s made the delivery of inputs much more reliable.
The results imply that stocks are a measure of the risk of a firm''s environment. Economic reform is not just about ''getting prices right'' but also about releasing firms from the need for holding large inventories.
''Inventories and Risk in African Manufacturing'' by Marcel Fafchamps, Jan Willem Gunning and Remco Oostendorp is published in the October 2000 issue of the Economic Journal. Fafchamps is at Oxford University; Gunning and Oostendorp are at the Free University Amsterdam.