4 Input Tangibility, Wealth, and Creditor Protection

Firms’ Trade-Financing Decisions during Crises



55



–

–

wealth decreases (A2 ≤ A < A3), the incentive constraint on the bank becomes

–

–

stringent, and the shadow cost of bank credit rises. When A1 ≤ A < A2, the two

sources of finance cost the same, but firms are not constrained by suppliers and

can use trade credit to keep investment and input combination constant (the dotted line does not shift upward in figure 2.4) and increase trade credit intensity (the

–

dotted line shifts upward in figure 2.3). When A < A1, the change in f makes the

entrepreneur’s moral hazard more severe in relation to both bank and supplier.

Thus, both trade credit intensity and asset tangibility increase, as shown by the

upward shift of the dotted lines in both figures.

The preceding analysis allows the authors to obtain the following predictions:

• Prediction 1. Credit-constrained firms have higher trade credit intensity and

use technologies more intensive in tangible assets than unconstrained ones.

Moreover, assuming that countries differ only in the degree of creditor protection, that leads to prediction 2.

• Prediction 2. In countries with weaker creditor protection, credit-constrained

firms have higher trade credit intensity and a technological bias toward tangibles. Unconstrained firms have the same trade credit intensity and input

tangibility across countries with different degrees of creditor protection.

If one takes into account that credit-constrained firms are more widespread in

countries with weaker creditor protection, prediction 2 is consistent with two

distinct sets of empirical evidence. First, there is a greater use of trade credit in

countries with less creditor protection, including developing countries (for

example, Rajan and Zingales 1995). Second, firms in developing countries have

a higher proportion of fixed to total assets and fewer intangible assets than those

in developed countries (for example, Demirgüç-Kunt and Maksimovic 1999).

This chapter thus offers a theory that reconciles these distinct findings.

Conclusions

The chapter has investigated the determinants of trade credit and its interactions

with borrowing constraints, input combination, and creditor protection. By interacting two motivations for trade credit use (liquidation and incentive motive),

which the literature had so far dealt with separately, the paper has derived a set

of new predictions, presented here as answers to the questions posed in the

introduction.

1. What justifies the widespread use of trade credit by financially unconstrained firms

that have access to seemingly cheaper alternative sources?



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An important result presented in this chapter is that financially unconstrained

firms (with unused bank credit lines) take trade credit to exploit the supplier’s

liquidation advantage.

2. Why is the reliance on trade credit not always increasing in the degree of credit

rationing?

If inputs purchased on account are sufficiently liquid, the reliance on trade

credit does not depend on credit rationing, but on the liquidation advantage.

3. Does input lending have an impact on the borrower’s choice of inputs?

The second major contribution presented in this chapter is the analysis of the

link between financing and input decisions. Specifically, more intensive use of

trade credit goes together with a technology biased toward tangibles, and the

bias increases as financial constraints tighten and creditor protection weakens.

In short, greater reliance on trade credit is associated with more intensive use

of tangible inputs.

4. Does the degree of creditor protection affect financing and input choices?

Better creditor protection decreases both the use of trade credit and the input

tangibility.

Notes

1. The model implicitly assumes the entrepreneur’s wealth is never so high as to finance entirely

the first-best investment.

2. For a discussion of this issue, see Fabbri and Menichini 2010.



References

Biais, B., and C. Gollier. 1997. “Trade Credit and Credit Rationing.” The Review of Financial Studies

10 (4): 903–37.

Brennan, M., V. Maksimovic, and J. Zechner. 1988. “Vendor Financing.” The Journal of Finance 43 (5):

1127–41.

Burkart, M., and T. Ellingsen. 2004. “In-Kind Finance: A Theory of Trade Credit.” American Economic

Review 94 (3): 569–90.

Demirgüç-Kunt, A., and V. Maksimovic. 1999. “Institutions, Financial Markets, and Firm Debt

Maturity.” Journal of Financial Economics 54: 295–336.

———. 2001. “Firms as Financial Intermediaries: Evidence from Trade Credit Data.” Policy Research

Working Paper 2696, World Bank, Washington, DC.

Fabbri, D., and L. Klapper. 2009. “Trade Credit and the Supply Chain.” Unpublished manuscript,

University of Amsterdam. http://www1.fee.uva.nl/pp/bin/859fulltext.pdf.

Fabbri, D., and A. Menichini. 2010. “Trade Credit, Collateral Liquidation and Borrowing Constraints.”

Journal of Financial Economics 96 (3): 413–32.

Ferris, J. S. 1981. “A Transaction Theory of Trade Credit Use.” The Quarterly Journal of Economics

96 (2): 247–70.



Firms’ Trade-Financing Decisions during Crises



57



Fisman, R., and I. Love. 2003. “Trade Credit, Financial Intermediary Development, and Industry

Growth.” The Journal of Finance 58 (1): 353–74.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. W. Vishny. 1998. “Law and Finance.” Journal of

Political Economy 106 (6): 1113–55.

Long, M. S., I. B. Malitz, and S. A. Ravid. 1993. “Trade Credit, Quality Guarantees, and Product

Marketability.” Financial Management 22 (4): 117–27.

Marotta, G. 2005. “Is Trade Credit More Expensive than Bank Credit Loans? Evidence from Italian

Firm-Level Data.” Unpublished manuscript, Department of Political Economy, University of

Modena and Reggio Emilia, Italy.

Mian, S. L., and C. W. Smith. 1992. “Accounts Receivable Management Policy: Theory and Evidence.”

The Journal of Finance 47 (1): 169–200.

Petersen, M. A., and R. G. Rajan. 1997. “Trade Credit: Theories and Evidence.” The Review of Financial

Studies 10 (3): 661–91.

Rajan, R. G., and L. Zingales. 1995. “What Do We Know about Capital Structure? Some Evidence

from International Data.” The Journal of Finance 50 (5): 1421–60.

Summers, B., and N. Wilson. 2002. “Trade Credit Terms Offered by Small Firms: Survey Evidence

and Empirical Analysis.” Journal of Business and Finance Accounting 29 (3–4): 317–35.



3

Interfirm Trade Finance:

Pain or Blessing during

Financial Crises?

Anna Maria C. Menichini



The severe recession that hit the global economy in 2008–09, causing low or even

negative growth rates, caused widespread contractions in international trade in

both developed and developing countries. The World Trade Organization

reported that global trade volume contracted by 12.2 percent in 2009 because of

the collapse in global demand brought on by the biggest economic downturn in

decades (WTO 2010).

The contraction in international trade has been accompanied by a sharp

decline in the availability of trade finance and an increase in its cost. The decline is

only partly explained by the contraction in demand; a joint qualitative survey

by the International Monetary Fund and the Banker’s Association for Trade

and Finance—now merged with International Financial Services Association

(BAFT-IFSA)—found that trade finance has been constrained and its cost has

increased, particularly in some developing countries, suggesting that part of the

reduction in trade transactions reflects a disruption of financial intermediation

(IMF-BAFT 2009). Although recent survey updates report signs of timid

improvement in credit availability, the recovery prospects of trade finance markets remain weak (IMF-BAFT 2009; Malouche 2009).

The situation has raised concern, especially for firms operating in developing

countries that trade in low-margin products in long manufacturing supply chains

and rely heavily on trade finance to support both their exports and imports. With

restricted access to financing and increased cost, these firms may have difficulties

maintaining their production and trade cycle. Fear that these difficulties could

59



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further slow world trade has triggered government initiatives to support trade

finance (Chauffour and Farole 2009).

This chapter focuses on interfirm trade finance—the finance that exporters

provide to importers to buy goods from overseas and that exporters also receive to

help them produce the goods to export and finance their extensions of credit to

importers.1

Three stylized facts are striking and suggest that a closer look should be

devoted to this specific form of financing:

• Interfirm trade finance is one of the most important sources of short-term

financing for firms around the world (Petersen and Rajan 1997).2

• It tends to be relatively more prevalent for firms in developing countries

(Demirgüç-Kunt and Maksimovic 2001; Beck, Demirgüç-Kunt, and Maksimovic

2008).

• Its use tends to increase in times of crisis (Calomiris, Himmelberg, and Wachtel

1995; Love, Preve, and Sarria-Allende 2007).

Given these facts, this chapter aims to convey an understanding of whether

interfirm finance presents features that can shield it from a general credit squeeze

or, rather, constitutes an extra element of tension (especially from the viewpoint

of developing and low-income countries) that justifies specific, differential treatment by policy makers.

According to these features, the chapter identifies measures to increase access

to this form of finance—measures that go in the direction, on one side, of creating

the conditions to fully exploit its potential advantages, and, on the other, of identifying market participants that are more likely to be exposed to market failures.

These measures include

• creating or improving information sharing mechanisms;

• promoting institutional reforms to increase the efficiency of the legal and judicial

system; and

• creating the conditions for exploiting the benefits of structured financing

schemes, especially in developing countries.

The rest of the chapter explores the main features that distinguish interfirm

international trade finance from alternative sources of financing; evaluates the

potential effects of a financial crisis on reliance on this form of financing among

firms in developing countries; and discusses measures to increase access to this

financing in times of crisis.



Interfirm Trade Finance: Pain or Blessing during Financial Crises?



61



Features of Interfirm Trade Finance

Firms simultaneously take credit from their suppliers and provide credit to their

customers. Thus, their balance sheets present both financial assets (receivables

from the customer) and liabilities (payables to the supplier). Although it may

seem puzzling that, in the presence of specialized financial intermediaries, firms

both receive and extend trade credit, the dual practice can be rationalized in various ways.

Offering trade credit may be profitable because accounts receivable can be collateralized and used to obtain additional financing against them (Burkart and

Ellingsen 2004). Alternatively, demanding trade credit may allow firms to hedge

their receivables risk (Fabbri and Klapper 2009). Or it may result from firms having trouble collecting from their own customers and being forced to delay paying

their suppliers (Boissay and Gropp 2007).

Alternative rationales stress the advantages that interfirm credit presents over

other forms of credit. The problem of borrower opportunism that plagues any

lender-borrower relationship is less severe with interfirm trade finance than with

other sources of financing for various reasons. First, the supplier might have private information regarding the customer’s creditworthiness that other financial

intermediaries do not have (Biais and Gollier 1997)—because, for example, their

repeated business relations facilitate the establishment of a relational contract,

which is especially valuable when contract incompleteness renders contract

enforcement difficult and costly. In such cases, agreements must be enforced

informally or be self-enforcing; through repeated relations, parties abide by the

agreements because they know that compliance will be rewarded with future business gains. Reputation, therefore, becomes sufficiently valuable that neither party

wishes to renege on the deal.

Another factor behind the ameliorated incentive problem of interfirm financing has to do with the nature of the supplier-customer lending relationship,

which, unlike other credit relationships, involves an exchange of goods rather than

cash. Because goods are not as liquid as cash, defaulting on the supplier may provide limited benefits to the customer (Burkart and Ellingsen 2004). Moreover,

because some tradable goods are less liquid than others, the benefits of defaulting

may be further reduced. Thus, the less-severe incentive problem implied by goods

lending is strictly related to the characteristics of traded goods.

Besides providing low benefits, defaulting on the supplier may also be costly.

When the client cannot easily and rapidly secure the same goods elsewhere or

when the goods supplied are tailored to the needs of a single customer, the supplier has considerable market power; it can threaten to stop deliveries if clients fail

to pay and, thus, can enforce debt repayment better than financial intermediaries



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Trade Finance during the Great Trade Collapse



can (Cuñat 2007). As a result of the reduced buyer opportunism in all the above

cases suppliers are willing to lend more liberally.

Another possible determinant of trade credit use lies in the supplier’s better

ability to liquidate the goods supplied in case of the customer’s default (Frank and

Maksimovic 2004; Fabbri and Menichini 2010). The viability of this solution

depends again on traded-goods characteristics (in that not all goods have a liquidation value in case of default) as well as on the characteristics of the legal

system. Although these advantages may be significantly diluted when firms

trade internationally, some of them may still be relevant. In particular, it is still

true that when traded goods are highly specific, there is little scope for the customer to behave opportunistically, even in an international context, or that strong

supplier-customer relationships can develop among firms that trade internationally because of either long-term business interaction or difficulties in replacing

the supplier. The next section elaborates further on some of the aspects that seem

most relevant, both theoretically and empirically, in a crisis scenario.

The Role of Traded-Goods Characteristics

Some of the theories briefly surveyed imply that the willingness to extend trade

credit may be related to the characteristics of the goods traded. Three factors

related to those characteristics could facilitate interfirm credit relationships:

(a) the possibility of diverting the goods traded; (b) the ease of switching to

alternative suppliers; and (c) the traded goods’ collateral value. To highlight the

relevance of these factors, the goods are classified into three broad categories:

• Standardized goods can be used by many different customers and thus have a

high resale value. Consequently, it is easy for the buyer to divert them. Moreover, because of their widespread use, any agent can easily sell them, which

implies that their suppliers are easily replaceable. Last, they may have high liquidation value in case of the buyer’s default if they have not been transformed

into finished goods.

• Differentiated goods are more specific and often tailored to the needs of particular customers, making it more difficult for customers to switch to alternative

suppliers. Because of their specificity, differentiated goods are particularly

valuable in the hands of the original customer—and, because there are fewer

alternative users, they are worth more in the hands of the original supplier and

more difficult to divert.

• Services have no collateral value and are almost impossible to divert. Moreover,

when the service provided is highly specific, it may be hard to find alternative

suppliers.



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63



The above analysis suggests that, because buyer opportunism is less severe for

firms in sectors offering differentiated goods and services, these firms should

extend more trade credit to their customers than firms selling standardized goods

(moral hazard hypothesis). Similarly, because differentiated goods are worth more

in the hands of the original supplier if the buyer defaults, firms selling (respectively buying) differentiated goods should offer (respectively receive) more trade

credit (liquidation hypothesis).

Using a sample of small U.S. firms, Giannetti, Burkart, and Ellingsen (2008)

show that service firms as well as firms producing differentiated products grant

more trade credit, while firms offering standardized goods offer less trade credit.

This evidence seems to support the moral hazard hypothesis but does not clearly

disentangle whether the driver of the results is the different diversion value of the

goods or the different cost in switching to alternative suppliers. McMillan and

Woodruff (1999) provide a direct investigation into the relevance of this last

motivation. Using survey data collected on a sample of Vietnamese firms, they

show that customers lacking alternative suppliers receive more trade credit.3

Regarding the collateral hypothesis, Giannetti, Burkart, and Ellingsen (2008)

provide some limited supporting evidence because firms offering differentiated

goods offer more trade credit, and firms buying a larger proportion of differentiated goods receive more trade credit. Petersen and Rajan (1997) also provide evidence in support of this hypothesis, using as a proxy for the liquidation advantage

the fraction of the firm’s inventory not consisting of finished goods.

The Role of Credit Chains

One distinguishing feature of trade credit is that it appears on both sides of the

firms’ balance sheets. In addition, because firms’ customers tend to belong to specific sectors, trade credit is not well diversified at the firm level. Debtors’ lending

and lack of diversification may constitute an element of great risk in times of crisis, particularly in light of the increasing organization of production in global

supply chains—that is, in a network of different types of companies that participate in the production of goods and services and ultimately deliver them to the

final consumer.

Aside from the aspects concerning technology improvements and efficiency

increasing methods of production, a key element in determining the competitiveness of each company along the chain, and ultimately of the whole chain of production, is related to financing. To guarantee themselves production orders, suppliers have to offer their customers attractive payment options. However, to

finance their credit extensions, they themselves need financing, which may be

extended by upstream suppliers or by financial intermediaries. When firms are



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perceived as potentially risky, or the financial sector is poorly developed—often

the case for firms in developing countries—access to credit for weak firms in the

chain may be difficult and costly.

All of this implies that, besides the supplying relationship, there may be strong

financial links among the various parties that interact along a supply chain. It is

no surprise, therefore, that interfirm trade finance becomes a particular issue of

concern in times of crisis, especially for developing countries, for a number of

reasons:

• Large international companies in developed countries have increasingly outsourced their production to low-cost sourcing markets. Disruptions in production may then arise if these suppliers have insufficient credit to finance the

shipment of their production to the next stage of the chain or even to carry out

production.

• Exports from emerging markets may highly depend on imports from developedcountry firms along the chain. A collapse in import financing may further

depress emerging countries’ exports, thus causing further disruptions in

production.

• Shocks to the liquidity of some firms, caused by the default of customers in a

depressed sector, may in turn cause default or postponement of debt repayments on their suppliers and propagate through the supply chain. With a large

proportion of their debts financed with trade credit (Demirgüç-Kunt and

Maksimovic 2001; Beck, Demirgüç-Kunt, and Maksimovic 2008), firms in

emerging countries might face stronger risks of propagation of shocks. The

scale of the damage depends on the length of the supply chain between constrained agents. In a recession, such chains are longer because more firms suffer negative shocks to their flow of funds. However, the presence of firms with

sufficient access to outside finance to absorb defaults without transmitting

them along the supply chain (deep-pockets firms) can weaken the credit-chain

propagation mechanism (Kiyotaki and Moore 1997).

The latter theory has received some empirical support. Raddatz (2010) provides evidence of the presence and relevance of credit chains for the transmission and amplification of shocks. Boissay and Gropp (2007) find evidence in

favor of the existence of trade credit default chains. In particular, firms that face

default are themselves more likely to default. Liquidity shocks are transmitted

along the trade credit chain until they reach deep-pockets firms, which ultimately absorb the shock. This theory suggests that external effects may be associated with supply-chain productions that might amplify the downsides of a

credit crunch.



Interfirm Trade Finance: Pain or Blessing during Financial Crises?



65



However, if it is true that interfirm trade finance may be a mechanism of propagation of shocks, it is also true that the repeated business interactions among

these firms may provide relevant benefits, especially during a financial crisis. The

typical fear that lack of trust in times of extreme uncertainty may squeeze intermediated trade finance, exacerbating the effects of the crisis, may be less of a problem for firms operating along supply chains. These firms are often involved in

long-term relationships and, thus, are less likely to experience an uncertaintydriven contraction in financing.4

This might also explain why trade credit is often countercyclical.5 In times of

recession, banks are more concerned about credit risk and less willing to extend

credit. Firms that rely more on relational contracts can increase their reliance on

trade credit; the relationship of trust with the supplier makes up for the higher

credit risk. Conversely, firms that rely on intermediated finance (formal contracts)

are likely to be squeezed by the credit contraction because the higher credit risk and

the lack of a credit history will discourage suppliers from extending them credit.

The Role of Institutions

One factor of crucial importance in determining the availability of international

trade finance is the legal system in which trading countries operate. Inefficiency of

the judicial system or of the legal system in general—in the form of inadequate

contract law or bankruptcy law—increases enforcement costs and thus commercial risk. This inefficiency affects the cost and the availability of financing, thus

hampering international trade.

How does the legal system affect interfirm credit? A number of papers find evidence that trade credit is relatively more prevalent in countries with worse legal

institutions and lower investor protection (Demirgüç-Kunt and Maksimovic

2001; Beck, Demirgüç-Kunt, and Maksimovic 2008). This seems puzzling because

one may expect that better legal institutions facilitate all types of borrowing,

including trade credit. This finding can nevertheless be explained by noting that,

unlike financial intermediaries, trade creditors may be able to more effectively

enforce contracts without resorting to the legal system by stopping future supplies. This intuition seems to be confirmed by a study, based on 1997 survey data

from small and medium-size manufacturers in transition countries, concluding

that ongoing relationships are more likely to be preserved when goods are complex, assets are specific, and it is difficult for customers to resort to alternative suppliers (Johnson, McMillan, and Woodruff 2002).

According to other studies, the varying efficiency of countries’ legal systems

might be related to their varying legal origins (La Porta et al. 1998). More precisely,

countries belonging to the common law tradition are found to have more efficient