The Liquidity Trap: Up to $1 Trillion in Excess Working Capital

Ernst & Young released a research report "All tied up" which examines working capital for the 2,000 largest companies in the US and Europe. The interesting find is that part of the liquidity crunch involved a deterioration in major companies' ability to manage their working capital, particularly inventory, in line with falling demand, volatile commodity prices, and volatile currencies.

While working capital as a percentage of sales fell from 2007-2008 (i.e. improved), in 4Q08, when the global crisis really hit hard, this reversed dramatically.

The sharply contrasting results in working capital performance for the full year and last quarter in both the US and Europe, partly reflect the impact of the global downturn in the final quarter of 2008, further compounded by heightened volatility in currency and commodity prices around the world.

In particular, inventory levels increased significantly in both the US and Europe (up by 10% and 4% respectively in the final quarter of 2008). Inventories did not decrease at the same rate as the drop in demand since companies’ supply chains were not responsive enough to keep pace.

As probably would be expected, if we look at industries, cyclicals tended to fare much worse and non-cyclicals in terms of managing working capital, due to the sharper declines in demand they experienced. This was one of the expressed conclusions from the report.

The implications of all this, and potentially the future upside, is that up to $1 trillion of potential global liquidity could be trapped in excess working capital alone. The liquidity crunch isn't just all about banks.

Thus, rather than prodding banks to lend more for the sake of lending, in the name of increasing liquidity, perhaps some liquidity-boosting efforts could be more safely focused on helping companies manage working capital better also. Bit of a stretch, but food for thought I feel. And this kind of liquidity would be the result of more efficient working capital management, rather than the pushing of potentially bad loans. Hat tip to Deal Book for this Ernst & Young release.