According to a survey by the IMF (2009), about 60% of all international trade transactions are financed via trade credits. Trade credits are extended bilaterally between firms and exist in the form of supplier credits and cash-in-advance. A supplier credit is granted from the seller of a good to the buyer such that the buyer can delay the payment of the purchasing price for a certain period of time. Cash-in-advance, in contrast, refers to payments made in advance by the buyer of a good to the seller. The intensive use of inter-firm financing is surprising given that financial intermediaries such as banks are supposed to be more efficient in providing credit to firms. Inter-firm financing is considered rather expensive with implicit annual trade credit interest rates amounting up to 40% (Petersen 1997).
Prevalence of inter-firm financing in international trade
The literature on trade credits provides various explanations why firms rely on trade credit financing. Lee (1993) and Long (1993), for example, have developed the warranty for quality hypothesis according to which firms extend a supplier credit to signal product quality to their (domestic) customers. Klapper, Laeven and Rajan (2011) provide empirical evidence that less trustworthy suppliers offer longer payment periods to their buyers. Only recently has the literature on trade credits taken international transactions into its focus. Schmidt-Eisenlohr (2012), Hoefele et al. (2012) and Antras and Foley (2011), for example, investigate the optimal choice of trade credit in international transactions. Auboin and Engemann (2014), Olsen (2011) and Glady and Potin (2011) deal with the question how bank-intermediated trade finance such as export credit insurance and letters of credit affect international trade. Why trade credits are so prevalent in international trade, despite their high cost, has been little studied so far.
In recent research (Eck et al. 2015), we explore the role of cash-in-advance financing for the export decision of firms. In contrast to most studies on trade credit financing, we focus on cash-in-advance financing instead of supplier credit financing. Cash-in-advance financing should have a stronger signalling function than supplier credits because it needs to be actively offered by the trading partner whereas a supplier credit can be extorted by simply overstretching the payment period.
The theoretical link between cash-in-advance financing and export participation
We start from the notion that international transactions suffer from aggravated information asymmetries due to longer distances and difficulties of tracing the foreign trading partner’s behaviour. Building on the warranty for quality hypothesis, we use a signalling model to show that cash-in-advance financing solves both a moral hazard and an adverse selection problem for an exporter. When exporting her good, an exporter is confronted with the problem that the foreign, unknown importer might be unable (adverse selection) and / or unwilling (moral hazard) to pay for the exporter’s good, once he has received it. If only bank financing is available less productive firms might be deterred from exporting since expected profits from exporting do not cover the associated costs in presence of high uncertainty. Paying part of the purchasing price in advance, however, the importer can signal his “quality” to the exporter such that asymmetric information is reduced. Even though cash-in-advance financing is intrinsically more costly than bank credits, this disadvantage is more than compensated for by the reduction of uncertainty. Expected profits rise and less productive firms can start exporting.
Empirical evidence on the effect of cash-in-advance financing on exporting
We use unique survey data on 1,196 German enterprises from the Business Environment and Enterprise Performance Survey in 2004 to test the effect of cash-in-advance financing on firms' export participation. The main advantage of this dataset is that it provides a precise measure of the use of cash-in-advance by firms which is the percentage of firms’ sales in value terms paid before delivery from their customers. A drawback is that transaction level data is not available in the survey. Therefore, we cannot single out cash-in-advance related to exporting activities compared to domestic activities. We thus restrict our analysis to linking the overall use of cash-in-advance by firms to their export participation decision.
The data reveal that exporters indeed use cash-in-advance financing more intensively than non-exporters. Figure 1 shows that about 44% of all exporters receive a positive share of their sales in advance, whereas only 33% of all non-exporters obtain advance payments. The average share of cash-in-advance received is very similar for both groups but marginally higher for exporters.
Figure 1. The use of cash-in-advance financing by exporters vs. non-exporters
We also explore how the availability of cash-in-advance payments by trading partners affects firms’ decision to export. Whether or how much cash-in-advance financing a firm receives is certainly not randomly assigned across firms. It might depend on unknown factors such as the degree of uncertainty with regard to the exporter’s trading partner, for example. To tackle endogeneity of our variable of interest, we rely on instrumental variable estimation. As an instrument for cash-in-advance financing, we use the degree of bargaining power that a firm has vis-à-vis its customers. The higher the bargaining power, the more likely the firm is to receive cash-in-advance from its trading partners.
As Table 1, column 1 shows, firms that receive a 1% higher share of cash-in-advance have a 15% higher probability to export. Thus exporters indeed seem to benefit from receiving prepayments from their customers. According to our theoretical results, we would expect that in particular less productive firms benefit from access to cash-in-advance financing since these firms might not be able to export in the absence of prepayments. Columns 2 and 3 give the differential impact of cash-in-advance financing on exporting for less and more productive firms, respectively. As less (more) productive firms we define those firms that have a labour productivity level below (above) the median labour productivity level. Less productive firms tend to benefit indeed more strongly from a 1% increase in cash-in-advance financing than more productive firms.
Table 1. Effect of cash-in-advance financing on the probability to export of firms, IV estimation
Note: ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
Alternatively, we also test our hypothesis for small vs. large firms with the median number of employees as cut-off. Columns 4 and 5 suggest that the effect of cash-in-advance financing on export participation is driven by small firms. Small firms that experience a 1% increase in their cash-in-advance share can increase their export probability by 15%. In contrast, larger firms do not significantly benefit from additional cash-in-advance.
Conclusion
Taken together, our results strongly support the hypothesis that cash-in-advance financing fosters export participation in particular of those firms that tend to experience greater difficulties in entering foreign markets. Cash-in-advance serves as a credible signal of quality and reduces part of the high uncertainty in international trade. If asymmetric information makes exporting less profitable, cash-in-advance can help firms overcome productivity frictions if other firms signal their reliability in form of cash-in-advance. Despite higher implied costs, this in turn can facilitate entry into exporting, in particular for less productive firms. The strong export fostering effect for German firms in spite of the rather well-developed German credit market points to the existence of high uncertainty in international markets.
Editor's note: The article solely relates to the work of Katharina Eck and Martina Engemann during their PhD at the University of Munich and does not include any opinion of the Federal Ministry for Economic Affairs and Energy nor the Federal Chancellery of Germany.
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