Trade Credit and Contract Enforcement Reforms: Evidence from a Natural Experiment in India
62 Pages Posted: 1 Mar 2012 Last revised: 27 May 2013
Date Written: February 27, 2012
Abstract
Large literature on financial development, legal origin and institutional environment suggests a negative association between use of trade credit and legal rights for secured creditors like banks and financial institutions. In countries with weak legal institutions, firms credit-rationed from banks take costly credit from suppliers. We test this hypothesis using exogenous variation in legal institutions in India. The present study uses the establishment of Debt Recovery Tribunals in different states in India at different points in time as a natural experiment and tests this proposition. Using a large panel of 1661 firms over the period of 1992-2002, for the sample firms, the difference-in-differences estimates suggest that better enforcement of legal rights of banks and financial institutions reduces the use of trade credit as proportion of total borrowings and the ratio of trade credit to bank credit by almost 2% and 13% respectively with cost saving of $0.12 mn, which is about 1% of the total interest paid by the median firm. The results suggest this effect as a demand-side effect. In addition, we test recent phenomenon of liquidation advantage of suppliers over other creditors in theoretical trade credit literature. We find strong evidence for collateral liquidation theory and financial constraints theory of trade credit, while weak evidences for product quality theory and firm riskiness theory. We also find that firms having prior relationship with the private sector bank tend to use less of trade credit and substitute with bank credit, while having a prior relationship with a public sector bank do not make such difference. The results are robust to various specifications and after controlling for state-specific trends.
Keywords: Trade credit, collateral, asset tangibility, financial constraints, creditor protection, contract enforcement reforms
JEL Classification: G32, G33, K22
Suggested Citation: Suggested Citation