Trade credit and exchange rate risk pass through

Summary

Focus

We model the transmission of exchange rate risk via firm balance sheets along the supply chain. We document stylised facts in the data linking foreign currency debt to trade credit lending (ie accounts receivable). We develop a stylised model where firms with access to foreign currency debt sell to firms downstream on credit. We analyse the implications of exchange rate risk and the consequences of its realisation. We validate theoretical predictions in a cross-country data set of firms in 19 emerging market economies.

Contribution

Foreign currency debt is an important source of financing in emerging markets, but it exposes the borrower to exchange rate risk whereby the value of their debts rises when the currency depreciates. Trade credit is an important source of financing for borrowing firms and cash flow for lending firms. Using our model, we examine how exchange rate risk can pass through to supply chains via its effects on trade credit. We further quantify the impact empirically and discuss the implications for the macroeconomy.

Findings

Large firms borrow in foreign currency and are net providers of trade credit to firms in their supply chains. Our model illustrates how trade credit loosens borrowing constraints and allows for higher production. Furthermore, the more firms are financially constrained, the more they are likely to pass exchange rate shocks to their balance sheets onto their trading partners. We document that these predictions from the theory hold in the data. Trade credit constitutes an important transmission mechanism of exchange rate shocks, but firms tend to protect their trading partners.

Abstract

Large firms borrow in foreign currency and are net providers of trade credit to firms in their supply chains. We model the transmission of exchange rate risk via firm balance sheets along the supply chain. Trade credit loosens borrowing constraints and allows for higher production. Furthermore, firms are more likely to pass-through exchange rate shocks to their balance sheets onto their partners the more they are financially constrained. We validate these predictions using a quarterly firm panel for 19 emerging markets. Trade credit constitutes an important transmission mechanism of exchange rate shocks, but firms tend to protect their trading partners.

JEL Classification: E32, G21, G32, F31, F34

Keywords: trade credit, financial constraints, supply chains, exchange rate volatility, imperfect pass through