Enforceability in Trade Credit: Financial Aspects of Transactions with FDI

Seiro Itoh, Mariko Watanabe and Noriyuki Yanagawa

Discussion papers from Research Institute of Economy, Trade and Industry (RIETI)

Abstract: This paper documents financial aspects of transactions and trade credit supply behavior with foreign direct investment (FDI) among small- and medium-sized enterprises, based on two original surveys. The surveys, conducted in four cities in China in 2003, were designed to uncover the nature of inter-firm transactions, trade credit and other financial conditions. Literature on FDI mainly refers to technology transfer, employment, or investment. This paper focuses on the role/significance of FDI in the supply of trade credit due to its enforcement technology of trade credit. Yanagawa, Ito, and Watanabe (2006) developed an incomplete contract model wherein when the seller has a higher enforcement technology or the buyer has richer liquidity, both trade credit and transaction volume will increase. In this paper we first compute the "enforcement probability" of each seller then test the propositions of the model. We confirm that (1) FDI and G firms provide larger trade credit. (2) This is due to their higher enforcement probability in trade credit. Furthermore, (3) higher enforcement probability has a positive external effect in enhancing the trade credit and transaction volume of indirect transaction partners. However, we also find that (4) in order to raise the probability of "no default," enhancing the ratio of cash on delivery is a necessary measure. (5) A more competitive supplier will prefer cash on delivery payment and consequently will provide less trade credit to the economy. (6) With a shorter transaction period, the supplier will provide larger trade credit. This implies that firms with a stronger bargaining power prefer providing no trade credit though they can expect higher enforcement probability, thus reduces the volume of economic activity. These negative forces against enhancing trade credit and economic activity exist at a substantial level in China. Because of this force, a strategic default problem persists in China even 30 years after the transition began.

Pages: 40 pages
Date: 2007-05
New Economics Papers: this item is included in nep-int and nep-tra
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