Fix the financing of supply chains

More worrying evidence was seen in Chile, where the government restricted the length of payment terms that one large retailer could impose on smaller suppliers. In response, the retailer significantly reduced its trade volume with these small suppliers and chose to source more goods from within their own subsidiaries rather than from external suppliers.

Reducing inventory and damaging financials: evidence from France retailers

Examining trade credit regulations through a supply chain lens, our recent research focused on a major investment in the supply chain – inventory. A healthy level of inventory at each tier of the supply chain is essential to managing the various risks in the chain that range from changes in customers’ taste to supplier disruptions. As such, inventory represents a substantial amount of investment for businesses. For example, among public retailers, inventory accounts for more than one third of their total assets.

The linkage between trade credit and inventory is intuitive: by providing trade credit, the seller shares the buyer’s inventory cost and risk, which would otherwise be borne solely by the buyer. Such sharing incentivizes the buyer to hold a higher level of inventory, which, in turn, would better serve customer demand and eventually not only increase the seller’s own sales, but also benefit the entire supply chain. Therefore, restricting trade credit usage below the equilibrium level may undermine this link and lead to under-investment in inventory and subsequently impaired supply-chain performance. Could such a phenomenon be observed because of the recent restrictions on trade credit?

To quantify this impact, we focused on France’s LME, which restricted the trade credit duration to 60 days for most French firms. In order to isolate the impact of the legislation, it is necessary to identify a set of control firms that were comparable in all respects except for their exposure to the LME. Given that most French firms were subject to the new legislation, we combined companies from other EU countries to create comparable synthetic “twins” of each French firm.

Furthermore, we sought to eliminate the potential impact of other confounding factors (such as the 2008 Global Financial Crisis) that might have affected French businesses differently from their non-French counterparts. Specifically, we use a subset of French companies and their respective European “twins” that were unaffected by the LME (their trade credit usage was already below the 60-day threshold) as a baseline for calculating a relative effect that is free of confounding factors .

We found that the LME had a significant impact on retailers’ inventory investment. Taking hardware retailers as an example, the LME caused a 16 percent decline in trade credit, which subsequently led to an 11 percent reduction in inventory.

A drop in inventory is not only going to lead to emptier shelves and more unsatisfied customers, but also hurt retailers’ financial performance. Indeed, we observed a 15 percent drop in revenue and a 3 percent decline in gross profit for retailers due to trade credit restrictions.

Supply Chain FinTech: Potential and Challenges

As our research shows, government regulations that directly limit the use of trade credit are not the panacea. In fact, one advantage of trade credit is that it is deeply integrated in supply chain transactions and allows for more flexible allocation of working capital among different stakeholders. Rigid government regulation kills such flexibility.

Instead, we argue for a market-based approach that incorporates “supply-chain fintech”, which uses digital technologies to facilitate the financial flows in the supply chain. By enabling better visibility and pricing flexibility, supply chain fintech could not only better incentivize large companies to pay their suppliers when the latter need capital, but also tackle other challenges in trade finance.

For example, one headache faced by credit-starved SMEs is that banks or their large suppliers do not lend to them. The Asian Development Bank estimated the global “trade finance gap” sits at $1.7 trillion, with small and medium-sized enterprises accounting for half of the total.

Reasons for this finance gap vary: lack of collateral; information asymmetry regarding the condition of the would-be borrower; regulatory requirements that are difficult for lenders to fulfill, such as know-you-customer; and low profitability.

Digital technologies could help overcome these difficulties. Internet-of-things could help monitor inventory, allowing companies to unlock their collateral value. Blockchain-based consortiums are working on breaking information silos and providing end-to-end supply chain visibility. Finally, big data and analytics offer the potential to better identify supply chain stakeholders in need of credit and assess their risk.

Offering such suggestions inevitably brings to mind the 2021 collapse of Greensill, the supply-chain-finance business that engaged, among others, former British Prime Minister David Cameron. The collapse of Greensill, however, was a failure of neither trade finance in general nor technology in particular, but of risk management and corporate ethics.

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