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Higher interest rates place spotlight on supply chain finance

Longer sales cycles, higher inventory costs and a steady drumbeat of interest rate hikes have buyers and suppliers looking to stretch capital by using supply chain finance programs.

Supply chain finance is a short-term financing arrangement that speeds up the settlement of transactions between buyers and suppliers. It allows buyers to extend the payment window for purchases while suppliers get paid early. Supply chain finance allows both parties to optimize cash flow by using a financial institution’s balance sheet.

“We’re seeing growing interest amongst a number of different client communities,” Michael Stitt, head of trade and supply chain finance sales at U.S. Bank (NYSE: USB), told FreightWaves. He said the rising rate environment places incremental pressure on suppliers, many of which are small and don’t always have access to inexpensive capital.

The desire to build stronger, more resilient supply chains has been accelerated by the dislocation caused by the pandemic. Suppliers have struggled to procure the inputs and product needed to sell to buyers, which resulted in stockouts at the consumer level and exposed gaps in some of the nation’s largest supply chains.

“To keep things moving you need grease,” Stitt said. “Supplier relationships were always important but they’ve become very mission critical for our clients.”

Improved access to working capital helps smooth out choppiness in sales or elongated production lead times. In many cases the supplier is smaller than the buyer, and the program provides a reliable source of liquidity at a much cheaper rate than a supplier can get on their own. Also, the programs help buyers meet social responsibility and ESG targets when qualifying suppliers are active.

“For suppliers … where their business cycle is now somewhat fragmented in terms of the timings of the cash flows that are happening in and out of the company – if they can liberate cash earlier than they had in the past that is a clear benefit to them,” Stitt said.

Cost headwinds mount

Last week, the Federal Reserve raised interest rates by 75 basis points for a third consecutive time and pointed to future increases at levels above the consensus expectation at the time of the report. The central bank’s federal funds rate was increased to a range of 3% to 3.25%, the highest since 2008 and three full percentage points higher than where it stood before the hikes began in March. It also raised its year-end projection for the rate to 4.4% from 3.4% in June, and upped its 2023 forecast by 80 bps to 4.6%. No rate reduction is likely until 2024.

The actions are part of the Fed’s goal to reel in inflation and create “price stability.” The bank’s 2% inflation target is not expected to be achieved until 2025, although the inflation metric it follows is expected to dip below 3% next year.

Inventory costs are growing as interest rates and warehouse rents continue to step higher and some companies have more merchandise on hand than they have in the past. The costs aren’t likely to retreat anytime soon as industrial real estate vacancies remain as little as 3% in key markets and rents are likely to be up 25% this year.

It remains to be seen how inventory strategy will change for e-commerce providers on the down side of the cycle as they juggle carrying costs with the need to keep more stock in more ZIP codes to maintain competitive delivery windows.

“We spent a couple of decades with a lot of really big brains deploying technology so that you can hold less inventory – more of a just-in-time delivery of inventory,” Stitt said. The model was built on the premise that holding minimal amounts of merchandise would keep inventory costs, including financing expenses, down. However, the strategy doesn’t align well with rapid fluctuations in demand or consumer preferences, which were commonplace early on in the pandemic.

“All of that stuff works as long as the conveyor belt doesn’t break down,” Stitt added.

He said many of the buyers he works with are now moving to a “hybridized model,” which includes buying more product manufactured in Latin America. The approach has buyers balancing the increased cost of not procuring items at the lowest possible unit price with a reduction in transit costs as trade routes are shortened. Buying closer to home also provides them the ability to more quickly take inventories when demand surges.

Buyers have also been employing a just-in-case strategy around inventory as a safeguard to running out of stock again. Holding more merchandise on the balance sheet during an inflationary period is also creating incremental demand for supply chain finance programs as buyers look to extend payment terms.

“There’s always a balance that people are trying to find,” Stitt said.

Higher costs elevate risk profile somewhat

Increases in interest rates and other carrying costs can edge the risk profile higher.

“As you increase costs, you put stress on profitability and that puts stress on credit quality,” Stitt said.

The short duration (typically 60 days) of exposure, however, makes supply chain finance an attractive asset class. The programs are “self-liquidating” with invoices paid as the inventories are collected. So even if the program stops, there isn’t a long tail of exposure.

“We saw this in ’08 and ’09 … supply chain finance as an asset class, there were not a lot of banks that exited the market. They stayed in there even when the credit profile became very stressed across the economy. Its value as a solution was solidified in that crisis.”

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