# 1 Introduction

Trade credit is an important source of short-term financing for firms, not only in the U.S., as documented by Petersen and Rajan (1997), but also around the world. For instance, accounts payables are larger than short-term debt in 60 percent of the countries covered by Worldscope. Also, across the world most firms simultaneously receive credit from their suppliers and grant it to customers concentrated on industries. specific These characteristics of trade credit financing have led some authors to propose it as a mechanism for the propagation and amplification of idiosyncratic shocks. The intuition is straightforward; a firm facing a default by its customers may run into liquidity problems and default to its own suppliers. Therefore, a temporary shock to the liquidity of some firms in a network that borrows from each other may cause a chain reaction in which other firms also get in financial difficulties resulting in a large and persistent decline in aggregate activity. This idea was first formalized by Kiyotaki and Moore (1997) in a partial equilibrium setting, and recently extended to a general equilibrium environment by Cardoso-Lecourtois (2004) and Boissay (2006) who have also provided evidence of the potential quantitative importance of the mechanism by calibrating their models to the cases of Mexico and the U.S.

Anecdotal evidence from surveys of firms suggests that this mechanism is relevant at the microeconomic level. Bradley and Rubach (2002) found that 31 percent of a sample of 131 firms filing for bankruptcy in the U.S. reported the non-payment by customers and businesses as the major cause for bankruptcy, and 66 percent reported that the non-payment of trade creditors had a great adverse effect on their operations. Also, based on evidence from the U.K., Chittenden and Bragg (1997) argue that firms typically respond to late payment by customers by delaying their payments to their trade creditors. However, so far there is no formal systematic empirical evidence of the presence and importance of the transmission of shocks through credit chains, which has led to some skepticism on the relevance of this mechanism at the macro level.<sup>1</sup> This lack of evidence is most likely the result of the absence of data sources containing the information on trade credit relations among firms required for a direct test of the hypothesis that these relations transmit and amplify shocks.

This paper partly fills this empirical gap by providing systematic evidence of the presence of the credit-chain amplification mechanism and quantifying its importance. It does so by taking an indirect approach that exploits the implications of the mechanism for the comovement of different industries and relies on widely available industry-level data. The idea behind this approach is that although the exact relations among individual firms are typically unknown, existing input-output matrices provide information on the trade relations among industries that combined with firms’ balance sheets data can be used to build a measure of the use of trade credit along the chain of

> 1The reasons for this skepticism is that in some countries the amounts of net trade credit are typically small, as noticed by Coricelli and Masten (2004), which suggests the possibility that defaults may cancel out at the aggregate level if the network is circular. Basically this means that it is theoretically possible that each firm defaults on each other without affecting actual production decisions. Each firm obtains the liquidity it needs by defaulting on its suppliers

1