We use new data on French firms to investigate the role of trade credit links among firms. We find evidence that they result in chains of defaults, and argue that these chains serve a useful role in allocating liquidity from firms with access to outside finance to credit constrained firms. By defaulting on trade credit, credit constrained firms are able to alleviate the effects of adverse liquidity shocks. We find that a large portion of liquidity shocks are ultimately absorbed by unconstrained firms further down the trade credit chain. The evidence supports theories that view trade credit as an important insurance against liquidity shocks for credit constrained firms.
Trade credit is the single most important source of external finance for firms. It appears on every balance sheet and represents more than one half of firms’ short term liabilities and a third of all firms’ total liabilities in most OECD countries. Yet, trade credit tends to be very expensive with implicit annual interest rates of about 40%. This has sparked a large literature on why firms use trade credit despite its high cost. Many recent theories emphasize that firms use trade credit because they are unable to obtain funds from the financial sector.
A number of reasons have been offered why suppliers may still be willing to lend when banks are not, including that suppliers have more accurate information about their customers than banks (Biais and Gollier, 1997; Petersen and Rajan, 1997), that suppliers have advantages in liquidating collateral (Mian and Smith, 1994; Frank and Maksimovic, 2005; Longhofer and Santos, 2003), that moral hazard and cash diversion problems may be less important for inter firm relationships than for bank-firm relationships (Burkart and Ellingsen, 2004, Burkart et al., 2009) and that suppliers and their customers may have a common interest in mutual survival due to shared rents from long standing business relationships (Wilner, 2000; Cuñat, 2007).
This paper shows that trade credit serves two distinct functions. One, suppliers may insure their customers against liquidity shocks via trade credit links and second, liquidity is allocated within the corporate sector along trade credit chains to where it is needed most, i.e. where credit constrained firms experienced adverse liquidity shocks.
Much of the previous empirical literature, starting with Meltzer (1960) has examined whether firms increase their use of trade credit under adverse circumstances. Meltzer (1960) showed that in periods of monetary tightening, large liquid firms increase the amount of trade credit extended. In the same vein, subsequent empirical work has focused on the financing role of trade credit and the substitution effects between trade credit and bank loans at the aggregate level. Under the assumption that trade credit is a substitute for bank loans, the literature generally argues that simultaneous decreases in bank loans and increases in trade credit indicate that firms are unable to obtain financing from banks (Kashyap et al., 1993) and that trade credit works to mitigate the effects of firms’ financial constraints (Calomiris et al., 1995). This paper proposes a new empirical identification scheme for firms facing adverse shocks. Hence, it complements the literature showing that trade credit is counter-cyclical at an aggregate level.
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