Analysis Of Network Spillovers In Trade Credit Dynamics

Trade credit is a contract where a seller sells final goods to a buyer on account.Trade credit is different from consumer credit in that in consumer credit the suppliers supply the final goods to the final consumer. On the other hand, in trade credit transactions the supplier may supply the goods on credit to an intermediary like a whole seller of those goods. In a trade credit transaction it is probable that the counterparty might not be able to fulfill the contracted obligations. In the literature of finance, a risk that is associated with each party of the contract that the counterparty will not be able to accomplish its obligations is known as counterparty risk. This study examines the effect of counterparty risk on trade credit use. The change in the riskiness of a buyer can lead to change in the behavior of a supplier towards the use of trade credit. Similarly, the change in the riskiness of a supplier may change the patterns of trade credit use for the buyer. The study has reviewed a comprehensive literature available on trade credit use.The study has focused on the theories of trade credit and the previous research from all over the world. After looking at the detailed literature available on trade credit the study has found a gap that no study has investigated, i-e the effect of counterparty risk on trade credit use.To analyze the effect of counterparty risk on trade credit use the study has collected the data from the textile sector of Pakistan, for the years 2001 to 2011. The logic behind using the data from the textile industry is that it is the largest manufacturing sector in the economy of Pakistan. Moreover, a researcher can easily identify the suppliers and buyers of the textile produce and raw inputs in this industry. According to the nature of trade credit transactions, the study collected the annual data from the manufacturing firms related to the textile sector. To find the determinants of trade credit that determine the level of trade credit in Pakistani manufacturing sector, the study has also collected the data from all the manufacturing firms listed at The Karachi Stock Exchange. The purpose behind the investigation of determinants of trade credit is to find the appropriate control variables for the analysis of the effect of counterparty risk on trade credit.Counterparty risk is an important factor that determines the level of trade credit.But there is no study available that segregate its effect from other determinants. To develop the proxies for counterparty risk, the study has depicted a model for financial networks. Where, the change in the leverage of a supplier would lead to a change in the behavior of a buyer towards the use of trade credit. The study has also mentioned that this process can be bi-directional. The change in the leverage of a buyer would lead to change in the credit policy of a supplier. In this way, the credit policy of each party intrade credit transactions depends on the financial and risk position of the counterparty.At the same time, the behavior of a supplier towards the supply of the trade credit might depend on the leverage of the buyer and in the same way the behavior of a buyer towards the demand of trade credit may be determined through the leverage or financial position of a supplier.After scrutinizing the supplier-buyer relationship data, the study has found that an increase in leverage leads to the unavailability of bank loan for buyers. In the absence of bank loan, it is more probable that the buyer will seek an opportunity to obtain financing from the supplier in the shape of trade credit. Simultaneously, it has created an opportunity for suppliers to earn more profit by increasing their credit sales. The study reports that an increase in the leverage of the buyer results in increase in demand for trade credit. It is quite often that suppliers may try to attract the customer through granting goods on credit or a customer may also be interested to opt for trade credit as a second source of financing which may lead to the increase in trade credit supply.Results for the leverage of the buyer and supplier confirm this phenomenon.The literature confirms that availability of bank loan and access to the capital markets makes it easier for supplier to supply goods on credit. In other words, access to cheaper funds enables the supplier to meet credit requests from the buyers. On the other hand, lesser access to financial institutions and financial markets may create a liquidity problem for a supplier and make it harder to supply goods on credit. It is very hard for a risky supplier to arrange financing from financial institutions and from capital markets.In the light of empirical evidences the results also explain that an increase in leverage of the supplier would lead to the decrease in amount of trade credit supply. Unavailability of bank loan and lesser access to the financial markets may turn high leverage suppliers towards the informal financing channels like trade credit. Results confirm that demand for trade credit of a supplier increases when the supplier has a high leverage ratio.The study has also tried to find the determinants of trade credit supply and demand for listed manufacturing firms in the economy of Pakistan separately. Investigation of the determinants of trade credit makes it easier for the study to derive some factors that can also be used as the control variables in the analysis of counterparty risk in trade credit transactions.This study also answers the call for understanding trade credit determinants and consequences in different cultures and economic setups in order to be able to devise policies. Trade credit is affected by two types of factors including firm specific characteristics and macroeconomic conditions. This study tries to investigate the following firm specific variables such as firm size, liquidity, product quality, price discrimination, inventory and sales growth and found them significantly related to trade credit. Gross Domestic Product(GDP) is the variable which is used as macroeconomicvariable and found positively related to trade credit. The study has applied three models namely, Pooled Ordinary Least Square Model(POLS), Fixed Effects Model(FEM) and Random Effects Model(REM) to identify the model that is more appropriate for this study based on panel data. F-test and Hausman test are used to compare the estimated models and they give their justification in favor of Fixed Effects Model(FEM). The results of the study are in line with the theories of trade credit and the previous findings of the researchers.