1. ability of thosefirms that are more bank-dependent to

1. IntroductionAccording to the credit channel, monetary policy is transmitted to the real economythrough its effects on bank loans (bank lending channel) and firms’ balance sheetvariables (balance sheet channel). In the case of a tightening in monetary policy, forinstance, bank loans supplies to firms are reduced. This diminishes the ability of thosefirms that are more bank-dependent to carry out desired investment and employmentplans. Similarly, a tightening in monetary policy is associated with a rise inborrowers’ debt-service burdens, a reduction in the present value of theircollateralizable resources, and a reduction in their cash flow and net worth. Onceagain, this makes it more difficult and/or more costly for firms for which asymmetricinformation issues are more relevant to obtain loans, forcing them to reduce theiractivities (Mishkin, 1995; Bernanke and Gertler, 1995).A number of studies have estimated regressions of firms’ investment in fixedcapital or inventories on cash flow, the coverage ratio 1, the stock of liquidity, or otherbalance sheet variables, on various sub-samples of firms. These types of regressionscan be seen as indirect tests for the existence of a credit channel of transmission ofmonetary policy. In fact, if a firm’s activity is strongly affected by financial variables,then, in periods of tight monetary policy, when the supply of bank loans is reducedand all firms’ financial situations become worse, this firm will have to contract itsactivity. Furthermore, if the credit channel were operative, one would expect financialvariables to mainly affect the behavior of those firms which are relatively moreconstrained in credit markets (namely more bank-dependent firms, which are typicallysmaller, younger, and less collateralized), and this effect to be stronger in periods ofrecession and tight monetary policy.The majority of the above mentioned studies have found a positive correlationbetween financial variables and firms’ activities, generally stronger for firms facingtighter financing constraints (see for instance Fazzari et al., 1988; Kashyap et al.,1994; Carpenter et al., 1994, 1998; Guariglia, 1999, 2000 etc.). Yet, other authors,who have mainly focused on firms’ investment behavior, have found that thesensitivity of investment to financial variables is in fact weaker for firms likely to face1 The coverage ratio is defined as the ratio between the firm’s total profits before tax and before interestand its total interest payments. It indicates the availability of internal funds that firms can use to financetheir real activities and can also be thought of as a proxy for the premium that firms have to pay forexternal finance (Guariglia, 1999). The coverage ratio has been widely used in the literature on theeffects of financing constraints on firms’ activities (see Carpenter et al., 1998; Gertler and Gilchrist,1994; Guariglia and Schiantarelli, 1998; Guariglia, 1999, 2000; and Whited, 1992).3particularly strong financing constraints (Kaplan and Zingales, 1997; Cleary, 1999).The latter findings cast a cloud over the existence and the actual strength of a creditchannel2.One argument which could be put forward to explain why some firms exhibita low sensitivity of investment to financial variables is that, particularly in periodswhen bank-lending is rationed, or, more in general, when external finance becomesmore difficult to obtain and/or more costly, these firms make use of another source offinance to overcome liquidity shortages, namely trade credit.Trade credit (i.e. accounts payable) is given by short-term loans provided bysuppliers to their customers upon purchase of their products. It is automaticallycreated when the customers delay payment of their bills to the suppliers. Trade creditis typically more expensive than bank credit especially when customers do not use theearly payment discount (Petersen and Rajan, 1997)3. Yet, according to Berger andUdell (1998), in 1993, 15.78% of the total assets of small US businesses were fundedby trade credit. Similarly, Rajan and Zingales (1995) document that in 1991, fundsloaned to customers represented 17.8% of total assets for US firms, 22% for UKfirms, and more than 25% for countries such as Italy, France, and Germany. Finally,according to Kohler et al. (2000), 55% of the total short-term credit received by UKfirms during the period 1983-95 took the form of trade credit.It is therefore possible, that even in periods of tight monetary policy andrecession, when bank loans are harder to obtain and/or more costly, financiallyconstrained firms are not forced to reduce their investment too much as they canfinance it with trade credit4. Trade credit issuance can increase in periods of tight2 Cummins et al. (1999); Bond and Cummins (2001); and Bond et al. (2002) estimated Q-models ofinvestment augmented with cash flow, where firms’ investment opportunities are more accuratelycontrolled for than in traditional models, and found that the coefficients associated with cash flow werepoorly determined for all types of firms. They therefore concluded that cash flow attracted a positivecoefficient in studies such as Fazzari et al. (1988) simply because it proxied for investmentopportunities, which were not properly captured by the traditionally used measures of Q. Thisconclusion is challenged by Carpenter and Guariglia (2003).3 A common form of trade credit contract is known as the “2/10 net 30” type. “2/10” means that thebuyer gets a 2% discount for payment within 10 days. “Net 30” means that full payment is due 30 daysafter the invoice date. After that date, the customer is in default. The combination of a 2% discount forpayment within 10 days and a net period ending on day 30 defines an implicit interest rate of 43.9%,which can be seen as the opportunity cost to the buyer to forgo the discount in exchange for 20additional days of financing (Ng et al., 1999; Petersen and Rajan, 1997). Unfortunately, the data thatwe use in this study do not contain information on when the buyers making use of trade credit actuallymake their payments.4 Biais and Gollier (1997) claim that by using trade credit, firms that cannot initially access bank debtmay actually enhance their subsequent access to bank debt. The use of trade credit can in fact be seenas a signal revealing to banks the suppliers’ unique information relative to the firm, and causing banks4money (we will refer to this phenomenon as the trade credit channel hereafter)because the risks of issuing trade credit are always lower than those of issuing bankloans: suppliers can in fact closely monitor their clients during the normal course ofbusiness; they can threaten to cut off future supplies to enforce repayment; and caneasily repossess goods in case of failed payment (Petersen and Rajan, 1997; Kohler etal., 2000)5. The presence of a trade credit channel could therefore weaken therelationship between firms’ real activities and traditionally used financial variables,such as the coverage ratio and cash flow, and more in general, could weaken thecredit channel of transmission of monetary policy.Although the hypothesis that a trade credit channel might weaken thetraditional credit channel was first suggested in 1960 by Meltzer6, recent empiricaltests of the hypothesis are limited. Using US data, Nilsen (2002) shows that duringcontractionary monetary policy episodes, small firms and those large firms lacking abond rating or sufficient collateralizable assets increase their trade credit finance.Similarly, Choi and Kim (2003) find that both accounts payable and receivableincrease with tighter monetary policy. Using UK data, Mateut and Mizen (2002) andMateut et al. (2002) show that while bank lending typically declines in periods oftight monetary policy, trade credit issuance increases, smoothing out the impact of thepolicy. Focusing on net trade credit, Kohler et al. (2000) observe a similar pattern.Based on a disequilibrium model that allows for the possibility of transitory creditrationing, Atanasova and Wilson (2004) find that to avoid bank credit rationing,smaller UK companies increase their reliance on inter- firm credit. De Blasio (2003)uses Italian data and finds some weak evidence in favour of the hypothesis that firmssubstitute trade credit for bank credit during periods of monetary tightening. Finally,Valderrama (2003) shows that Austrian firms use trade credit to diminish theirdependence on internal funds. Except for the latter two studies, which are based onto update their beliefs about the quality of the firm, which might lead them to start supplying funds tothe firm (also see Alphonse et al., 2003).5 By helping a customer in difficulty to stay in business, suppliers may actually benefit in the longerrun, through future sales made to that customer (Atanasova and Wilson, 2001). Calorimis et al. (1995)provide evidence that in periods of recession, large firms borrow in order to extend more finance totheir financially constrained customers. Furthermore, Cunat (2003) documents that when customersexperience temporary liquidity shocks that may threaten their survival, suppliers tend to forgive theirdebts and extend their maturity periods at no extra cost (also see Petersen and Rajan, 1997; and Wilner,2000). Finally, it should also be noted that lending through trade credit might also serve non-financialpurposes: for instance, firms can use trade credit to price discriminate (Brennan et al., 1988; Petersenand Rajan, 1997).6 Also see Brechling and Lipsey (1963).5continental European economies, the above listed studies generally focus on thedeterminants of trade credit and on its behaviour over the business cycle, withoutlooking at how trade credit actually relates to firms’ real activities.This paper contributes to the literature by providing, for the first time, rigoroustests of whether trade credit affects UK firms’ activities and, more specifically, ofwhether the trade credit channel of transmission of monetary policy plays anoffsetting effect on the traditional credit channel in the UK (this hypothesis will bereferred to as the offsetting hypothesis hereafter). Focusing on the UK rather than oncontinental European economies is particularly interesting: the UK financial system isin fact mainly market-based, whereas continental European countries arecharacterized by bank-based financial systems (Demirgüç-Kunt and Maksimovic,2002). One would expect therefore the trade credit channel to be stronger in the UK.Yet Demirgüç-Kunt and Maksimovic (2001) document that firms in countries withlarger and privately owned banking systems generally offer more financing to theircustomers and take more financing from them. To perform our tests, we will make useof 609 UK manufacturing sector companies over the period 1980-1999, collected byDatastream7.In our econometric analysis, we will focus on the direct effect that trade creditplays on firms’ inventory investment, and on the indirect effect that it has on thesensitivity of firms’ inventory investment to the coverage ratio. Three reasons justifyour choice of inventory investment in our analysis. First, inventory investment plays acrucial role in business cycle fluctuations (Blinder and Maccini, 1991). Second,because of its high liquidity and low adjustment costs, inventory investment is likelyto be more sensitive to financial variables (including trade credit) than investment infixed capital (Carpenter et al., 1994). Third, trade credit is often related to thefinancing of inventories (Valderrama, 2003; Petersen and Rajan, 1997). We will onlyfocus on accounts payables as a measure of trade credit usage, considering the firmsin our data sets as borrowers8.7 These companies are all traded on the London Stock Exchange. Datastream has been widely used totest whether financial variables affect firms’ activities in the UK, and more in general to test for thepresence of a credit channel of transmission of monetary policy (see for instance Blundell et al., 1992;Bond et al, 2002; Bond and Meghir, 1994; Guariglia, 1999, 2000 etc.).8 Other authors (Kohler et al., 2000; Choi and Kim, 2003; De Blasio, 2003) also considered the roleplayed by trade credit extended. When bank lending is constrained, firms can in fact find additionalfinancial resources either by relying more on trade credit received or by extending less trade credit toother firms.6Our results suggest that both the trade credit channel and the credit channeloperate in the UK, and that there is evidence that the former channel weakens thelatter. We find in fact that when trade credit is added as a regressor to an inventoryinvestment equation which already includes the coverage ratio, it generally affects theinventory investment at both financially constrained and unconstrained firms. Yet, thecoverage ratio variable remains significant for the former firms. Furthermore, we findthat when the effect of the coverage ratio is differentiated acrossconstrained/unconstrained firms making a high/low use of trade credit, the coverageratio only affects inventory investment at those constrained firms which make a lowuse of trade credit. This suggests that using trade credit can help firms to offsetliquidity problems. All our results are robust to replacing the variables in the coverageratio with corresponding variables in cash flow. The finding that a strong trade creditchannel, able to weaken the credit channel, operates in the UK is important as thischannel is likely to dampen the effects of contractionary monetary policies, and morein general to make the recessions that generally follow these policies less severe.The remainder of this paper is organized as follows. In section 2, we describeour data and present some descriptive statistics. Section 3 illustrates our baselinespecification, our tests of the offsetting hypothesis, and our econometricmethodology. Section 4 presents our results and Section 5 concludes the paper.