2.1 Trade Credit
The importance of trade credit is documented in many studies at length. When I as a trader purchase something either from another trader or the manufacturer, for which I pay later, I am purchasing the product or service on ‘trade credit.’ Disparate sources indicate a variety of explanations of trade credit. Demirguc-Kunt and Maksimovic (2002) and Fisman and Love (2003) show that countries with weak legal systems rely on trade credit relatively much more. This is indeed true, especially in informal markets like Agra. The detailed empirical investigation of Petersen and Rajan (1997) concludes that firms engage in trade credit when credit from financial sources is unavailable. They propose that trade credit is used as ‘financing of last resort’ by highly constrained firms.10 However, for many informal small firms, the first resort itself is the trade credit and in situations of low levels of financial inclusiveness, bank loans may actually be the last resort, as I show in the case of Agra footwear industry. Using the same dataset as Petersen and Rajan (1997), Elliehausen and Wolken (1993) shows a 20% liability of small firms comprised of trade credit.
There are few hypotheses that concern trade credit. The information advantage hypothesis suggests that high information asymmetries will restrict the incentives of supplier (of trade credit) to offer credit (Schwartz, 1974). Biais and Gollier (1997) theoretically show that the extension of trade credit reveals that more information about the debtors lies with creditors than banks. This hypothesis was further built by Jain (2001). The switching cost hypothesis argues that trade credit may actually avoid default because transacting parties may often face high costs in switching their business partners (Cunat, 2007). The collateral hypothesis explains why the goods/products on which trade credit is being offered is actually a far easier commodity to liquidate for the purchaser of credit than for banks to do so, because the former is in the business of these very products (Mian and Smith, 1992; and Longhofer and Santos, 2003). The quality guarantee hypothesis argues that trade credit seeks to serve as a de facto guarantee of the product/service quality (Smith, 1987). As such, the choice of trade credit terms the supplier offers can reflect the degree of product quality (Emery and Nayar, 1998; Lee and Stowe, 1993; Long, Malitz and Ravid, 1993). This will only be true if the quality cannot be ascertained ex ante. However, all of these studies focus on formal markets. By demonstrating the functioning of Agra’s footwear cluster, we draw the attention of scholars to the examination of how these factors play out in the case of informal markets.
Ferris (1981) offers an insight into why trade credit may make sense if we focus on its function to manage liquidity. For small firms and ones in informal markets this is definitely the case. Also, scholarship that builds case for relational trade practices (McMillan and Woodruff, 1999; Johnson, McMillan and Woodruff, 2002; Uchida, Udell and Watanabe, 2007) has shown that in emerging markets generally (and in Japan in particular), higher trade credit is offered if trading relationships are longer. Informal markets, naturally, must show a very strong support for this theory, and we test it in this chapter.
Petersen and Rajan (1994) have shown that primarily, the cost of trade credit is the foregone discounts. This may show that trade credit could be cheaper than formal credit. This is illustrated empirically by Giannetti, Burkart and Ellingsen (2011). However, as I show through my empirical work, trade credit is significantly costlier than that offered by the banks, and markets which are unorganized, exhibit divergence from these conclusions. Brick and Fung (1984) propose that the function of trade credit – and this is usually missed in many scholarly surveys – is to avoid taxes. In informal markets, it does not seem to be of any importance. Another lesser realized function is that of exploiting opportunities for arbitrage when lending and borrowing rates differ (Emery, 1984). However, most informal markets are characterized by a high degree of information symmetry – as I show – making the likelihood of arbitrage low.
Perhaps the most interesting and yet unexplored finding of the literature on trade credit is that of trade credits by small firms. It is observed that more often than not, small firms despite being more capital constrained than big firms (Demirguc-Kunt and Maksimovic, 2002) sell relatively large amounts of their goods on credit in developing countries, as compared to small firms in developed nations (Horen, 2007). For instance, in 2006, a survey found that 72% of Mexican firms provided trade credit to their suppliers, and it was found that small firms were more likely to provide credit than larger firms (Horen, 2007). This was in contrast to the US, where small firms have been shown to provide less credit (Petersen and Rajan, 1997). This paper sheds light on how that could be the case.
2.2 Guarantee Contracts
Guarantee arrangements constitutes a person (or an entity) standing as surety for a second person’s obligation to a third. For example, one can consider my father offering to guarantee an education loan I am applying for in a bank. In the event that I fail to pay the loan on stipulated timelines, the bank will have the right to claim the payment from my father. Intercorporate guarantees, standby
letter of credit, construction suretyships, statutory and fidelity bonds, chattel papers, real estate mortgages, joint and several liability are some of the ubiquitous examples in commercial transactions (Katz, 1999). Scholarly work on guarantee contracts has been rather scanty.11 One notable work in this area has been by Katz (1999), which provides a rigorous theoretical framework to generalize. However, his work focuses on formal markets. In exploring the same theoretical construct, the paper proposes some departures.
It may be natural to think that the need to guarantee credit in informal markets would be relatively much higher than seen in formal markets. This is because defaults in formal markets can be challenged in the judicial system, while such a recourse is not available to players of unorganized markets. In this vein, scholars of institutional analysis may perhaps obtain interesting findings upon digging deeper into how unorganized markets develop guarantors and assessing their interest rates. This paper attempts to do precisely that for trade credit.