Interfirm Relationships And Informal Credit

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Interfirm Relationships And Informal Credit

• By John McMillan and Christopher Woodruff

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• In developed countries, well functioning legal
  system exists. Contracts are enforced through
  specific institutions such as the courts.
• However, in most developing countries, laws of
  contract are inadequate. Informal relationships
  substitute for the courts in allowing deals to be
  made.

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• The aim of this paper is to provide empirical
  evidence of relational contracting.
• Particularly, it studies what determines the
  level of business trust. The measure of business
  trust is the fraction of the payment made after
  delivery of the goods.

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• Relational contracting is can be regarded as a
  repeated prisoner dilemma game. The customer
  chooses between a short-term gain and a long term
  relational value.
• If the customer default, the supplier may refuse
  to provide credit next time or not trade with the
  customer any more. Moreover, other suppliers may
  know about this and make their decisions of trade
  and credit grand accordingly.

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• What determines the suppliers trust according to
  the model?
• The customers ability to find alternative
  trading partners
• The suppliers gathering of information about the
  customer
• Network relationships

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• First hypothesis customers lacking alternative
  suppliers will receive more trade credit.
• It is because there are higher long run
  relational value. The Customer would have higher
  cost of search for another supplier or larger
  transport costs in buying from another supplier.

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• Second hypotheses There will be more trade
  credit when the supplier inspects the customer
  directly and in relationships of longer duration
• The suppliers direct dealings with the customer
  might yield information about its
  creditworthiness.
• Cooperation might build up gradually as the
  supplier learns through trading about the
  customers reliability.

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• Third hypotheses a supplier belonging to a
  network will grant more trade credit.
• A network might provide information.
• Networks provide not only information about
  customers reliability but also extra ability to
  sanctions customers who renege.

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Data

• Data come from surveys of 259 nonstate firms in
  Vietnam
• Two waves firms in Hanoi in 1995-1996 and Ho Chi
  Minh City in 1997.
• Firms were drawn from lists of members of the
  Vietnam Chamber of Commerce and Industry. There
  may be potential sample selection problem and
  therefore the results may not be easily
  generalized.

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• The survey contains information on 518
  manufacturer customer relationships and 518
  manufacturer supplier relationships.
• State owned enterprises are eliminated. Also,
  relationships no longer ongoing are dropped. We
  end up with a sample of 242 customer
  relationships and 254 supplier relationships.
  Complete data are available for 224 customer and
  243 supplier relationships.

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• All are manufacturers.
• Most firms are new, with less than 4 years age.
  The duration of trade relationship may capture
  this dimension of firms characteristics.
• Most sales go to customers in the same city as
  the respondent. This is not the case for large
  firms which export more than a third of their
  production on average.
• One firm involves in more than one trading
  relationships.

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• The heart of the survey is a series of questions
  about the firms relationships with its first
  customer and its most recently added customer
  and with it longest running supply relationship
  and its newest supply relationship.
• For each of the four specific relationships,
  firms were asked what proportion of the sales
  price is paid in advance of delivery, at the time
  of delivery, and after delivery.

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• The portion of the bill paid after delivery is
  used as a measure of credit supply.
• Observed trade credit is the outcome of the
  supply of credit offered to the customer and the
  customers demand for credit. However, the
  authors argue that it does not matter since the
  demand for credit is not correlated with the
  independent variables.

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Empirical method

• The level of credit is treated as a censored
  variable, with the desired level of credit
  observed only when it falls between zero and 100
  percent.
• latent equation
• The observed level of trade credit offered
  customer i is

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• visited customer before first sale, currently
  visit customer at least weekly, and talk to
  other suppliers of customer at least monthly are
  at first excluded from the regression, because
  there is concern about their endogeneity.
  Suppliers providing credit to a customer may have
  a higher incentive to collect information about
  that customer
• Column (3) adds variables suggested by the
  literature of trade credit. Column (4) adds
  controls related to manufacturer and manager
  characteristics. These additional variables have
  little effect on the relational contracting
  coefficients.

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• Column (5) through (8) examine whether these
  determinants of the willingness to offer credit
  vary depending on whether the manufacturer is
  selling domestically or overseas, or whether the
  manufacturer is large or small

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• Some econometric suggestions
• marginal effect does not equal to the coefficient
• the sign is right, but the magnitude is wrongly
  reported in the table
• One firm has several trade relationships.
  Therefore, the error term may be correlated
  within one firm. This leads to biasness in a
  Tobit model. Measurement error of the dependent
  variable may also bring in some biasness.
• Samples are divided according to the suppliers
  size and whether its customer is domestic or
  overseas. In this way, we cannot easily tell
  whether the marginal effects are significantly
  different from each other. A more nature way is
  to add the interaction terms to deal with the
  random coefficient model.

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• Network membership provides a manufacturer both
  information about the reliability of trading
  partners and the ability to sanction.
• Information about the reliability of a customer
  is most valuable at the beginning of a
  relationshipthe effect diminishes over time
• Ability to sanction has more enduring
  effectconstant effect over time

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• Interations of the network membership variables
  with duration
• The chi-square tests indicate that the additional
  variables are not jointly significant for the
  network variables. The authors conclude that
  sanctions are a significant role of the business
  networks.
• Also interact visited customer before first
  sale with duration as a robust check. It shows
  diminishing effect over time.

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• The survey also contains data on trade credit
  received by the interviewed manufacturers from
  their longest continuing supplier and their
  newest supplier.
• Trade credit received from suppliers is similar
  in magnitude to that granted to customers. It can
  also be used as the dependent variable as a
  measure of suppliers trust.
• The advantage of using customer data is that we
  can control direct measure of creditworthiness of
  the customerreceiving loans from banks

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• Data on the manufacturers degree of lock-in to
  its supplier are provided by a question on how
  long it would take them to find alternative
  supplier in the event a supplier failed to
  deliver goods as promised.
• Measure of social networks is whether the
  supplier was managed by someone who was a family
  member or friend when the trading relationship
  started.
• Measure of business networks is whether its
  suppliers talked among themselves.

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conclusion

• A firm trusts its customer enough to offer credit
  when the customer finds it hard to locate an
  alternative supplier.
• The firms experience in dealing with the
  customer matter a longer duration of trading
  relationship is significantly associated with
  larger credit, at a rate that diminishes over
  time.
• Visiting a customer or supplier before the
  business relationship starts is associated with
  10 points more credit in the first year of the
  relationship, although the effect diminishes over
  time.

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• a customer identified through a business network
  receives ten to twenty percentage points more
  credit.
• When the firm talks regularly with other
  suppliers of the customer, it grants about 20
  points more credit.
• The network effects are enduring, suggesting that
  networks are used to sanction defaulting
  customers.
• Relational contracting is ambiguously
  efficiency-enhancing. Continuing to deal with the
  custom might mean refusing to deal with new
  entrants, which could result in some
  inefficiencies.