MONEY MATTERS
The necessary evil of inventory
There is a carrying cost but that's the price to pay if the goal of policy makers is to have stable prices
By JOSEPH CHONG
IMAGINE the following announcement: 'Due to an administrative oversight, HDB has discovered 10,000 unsold completed apartments. The Housing Board intends to sell these gradually over the next three years.' What would the impact be on HDB resale prices?
I posed this scenario and question to quite a few on April 1 recently and the answer was quick and unanimous - it would stabilise HDB re-sale prices. The recent triumph surrounding the announcement that HDB had managed to sell 31,000 completed flats and had no more unsold inventory is misplaced. I believe it is a policy error not to carry any unsold inventory.
It should be official policy for HDB to always carry a minimum of unsold inventory. Without ready inventory to sell, HDB would not be able to meet any sudden surges in housing demand or compensate for demand misestimates.
Inventory and spare capacity are a necessary evil if the goal of policy makers is to have stable prices across various markets. Indeed, we see this in fiscal and monetary targeting across the world daily.
For example, central bankers and markets around the world watch the unemployment rate very closely. We want a rate as close as possible to NAIRU but not zero. NAIRU is the Non-Accelerating Inflation Rate of Unemployment. That is, a steady state unemployment rate above which inflation would fall and below which inflation would rise.
NAIRU in the US is estimated to be about 5 per cent. If unemployment falls too low, it invariably leads to a spiralling jump in prices and eventually a bust in the economy as interest rates rise to quench inflation. Yes, there is carry cost of having unemployed people but the cost of a recession is far worse.
This also applies to the argument from HDB that unsold flats have a carrying cost. What is good for HDB may be bad for the wider Singapore economy. Without the stabilising effect of unsold ready-to-stay inventory, volatile housing prices carry a far bigger cost for the economy. In any event, unsold flats can always be sold to reflect their holding costs. In an upturn when demand surges, these should still fly like hot cakes.
Indeed, evidence of this stabilising effect of unsold inventory can be seen in 2005 to 2007. Despite a surging economy then, HDB resale prices moved up more modestly than private property. Indeed, I would argue that carrying unsold inventory intentionally would also allow HDB to influence to some extent private property prices.
Oil as example
A very good example of the stabilising effects of spare inventory is Opec, in particular Saudi Arabia. Spare production capacity (inventory stored underground) of about 5 million barrels per day or about 6 per cent of global demand has allowed Opec to keep prices at around US$80 per barrel. Prices shot up to US$140 per barrel in 2007 because Opec ran out of spare capacity. And the markets knew that.
In business, we would love to carry zero inventory but this is not possible as demand surges cannot be predicted with absolute certainty. Even build-to-order firms such as Dell carry inventory! If we have nothing to sell when demand picks up, business goes to the competition. Here again, the cost of losing business outweighs the cost of carrying inventory.
Unfortunately, the topic of inventory and spare capacity is often poorly reported or analysed in the financial media. It is however crucially important. Changes in inventory affect the measurement of true GDP growth and corporate profits. Misunderstand this and you may end up investing in property or your business on fall premises.
For example, the US reported 'sterling' GDP growth of around 5.6 per cent for 1Q 2010. See chart from Moody's Economy.com which shows this impressive trajectory. Unfortunately, the breakdown of data shows that more than 3.5 per cent from this 5.6 per cent comes from re-stocking. That is, final demand, which is the true level of growth, was only 2 per cent.
Indeed, this is affirmed by other data points. Currently, US real retail sales (ex-autos and gasoline) are growing at about 2 to 2.5 per cent annually.
When demand started to recover in the second half of 2009, US firms did not ramp up production because they were uncertain of the future. They sold from existing inventories. Now that things have stabilised, inventory has to be re-built because the shelves are nearly empty.
Unfortunately, the latest ISM data shows that the pace of inventory rebuilding is far greater than the pace of new orders - meaning that production has to be throttled back in the second half of 2010. I expect US GDP growth to taper off to 2.5 per cent by the end of 2010 - the level of sustainable final demand.
The big jump in Singapore's 1Q 2010 GDP numbers, led by manufacturing, is very likely due to this re-stocking in the US. Once the US is through re-stocking, Singapore's GDP will taper off as well. Therefore, it is premature for any hikes in CPF.
Does it make sense to stipulate a wage increase for labour just because companies are re-stocking? I thought growth through productivity was all about growing one's wages from higher skills and global relevance.
The author is CEO of financial adviser New Independent. He welcomes feedback at josephchong@ni.com.sg. This article is for information only. Readers should seek independent advice before making any investment decisions
Copyright © 2010 Singapore Press Holdings Ltd. All rights reserved.
Have more to spare: Without the stabilising effect of unsold ready-to-stay inventory of HDB flats, volatile housing prices carry a far bigger cost for the economy
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