The incidences of shocks rippling through supply chains during the pandemic have become more frequently reported, whether it’s semiconductor chips from Asia or drought-related wheat and corn shortages in the U.S. The risk to supply chains from natural disasters—hurricanes, earthquakes, droughts, and floods—experienced in the U.S. and other countries is more acute given potential climate risks. In new research, Finance Professor Ruidi Huang of SMU Cox and his coauthors show how firms react to natural disasters and what actions can help supply chains stay resilient. The research shows that disaster-affected firms in a supply chain can improve its resilience through the financing mechanism of trade credit.
Supply chain disruptions can impose large costs. Actual or perceived operating risks faced by a firm can alter how a supply chain functions and increase its fragility, especially when affected by natural disasters, according to Huang and coauthors Ersahin and Giannetti. Recently, semiconductor chip production was disrupted by events, including a plant fire in Japan (having also recovered from an earthquake) and the February freeze in Texas that halted production lines. Drought in Taiwan, a major chip-making hub, threatens to further reduce industry output, given the water demands used in the process. In August, Toyota announced cuts to production by 40% because of chip shortages, with Ford and General Motors also slowing production in the U.S., largely owing to the delta variant that has extended the pandemic. The links in the chain can become badly bent.
These disruptions may impact not only a supply chain and the disaster-affected firms but also a region’s comparative advantage and long-term growth, if relationships become severed, the authors note. “The disruptions that happen in a supply chain could be climate risk-related or a pandemic like COVID-19,” Huang explains. “These are more short-term incidences versus say liquidity shocks which can have different consequences.” Past research has shown that shock associated with supply chain disruptions do not result in a permanent loss of economic activity, according to Huang. “Yet, we know little about the mechanism limiting the fragility of supply chains,” he adds. “Our paper highlights the conditions under which climate risk may result in a loss of comparative advantage and have deleterious effects on firms and the local economy.”
Trade credit is the most important form of short-term financing for firms, supporting 90% of trade transactions. It’s like the circulatory system of trade. “Consider Walmart,” explains Huang. “For their suppliers, everything is on credit with them.” The authors are the first to show that trade credit in fact contributes to supply chain stability and they explore the ways in which firms choose to internalize the shock depending on competition.
Give (even though you’re hurting)
The study looked at data about supply chain relationships, including around 8,000 customers and suppliers from 2003 to 2019. The average firm had 21 customers and 20 suppliers in a chain. The authors analyzed accounts receivables and payables to proximate trade credit since the information is not readily available. To determine trade credit flows and exact amounts of trade credit, they had to work through multiple iterations of data (much of it hand-collected by reading firms’ annual SEC filings) to identify their “SEC sample” of 317 major customers and 430 suppliers.
They then looked at a database of hazards and losses in the U.S. from the Center for Emergency Management and Homeland Security. These were major disasters costing at least $1 billion. The sample included 42 blizzards, earthquakes, floods, and hurricanes, which were generally localized and affected 47 counties on average, but at the most 156 counties in a quarter. Parts of the Southeastern U.S., Florida for example, and the Gulf Coast were frequently hit by disasters, as well as California. Overlaid with the sample of the firms culled by the authors, however, they noted that the location of the customers and suppliers of disaster-affected firms is much less localized and includes counties never hit by disaster as well as those hit often.
Huang and coauthors found that firms affected by natural disasters extend trade credit to downstream customers, especially when they are important. Additionally, credit extended to a disaster-affected firm from upstream suppliers improves the resilience of supply chains.
The results were surprising. Huang notes, “I’m the factory firm that’s on fire and I give more credit to my customers. Why?” Other research papers suggest that when there’s a liquidity shock, the affected firms require faster payments from their customers. “Our findings say: ‘Keep the money longer; we want you to remain a customer,’” he adds. “The suppliers of the disaster-affected are aware of the issue and they pitch in to provide more trade credit to affected firms, which then allows troubled firms to increase trade credit provision to their customers. It’s a counterintuitive finding,” says Huang. However, it is a solution that keeps the supply chain stable. Firms in concentrated industries extend less trade credit provision than those in competitive industries. Financially-constrained firms also have less range of motion on trade credit provision.
Business climate adaptation solution
“If there’s a flood or an earthquake, those shocks propagate,” Huang says. “My supplier will be affected. My customers are affected, like the chipmaker whose final customer waits six months to receive a computer or a car.” Trade credit has been ignored— how it keeps everything going. “When you offer trade credit, things become stable and you can recover a lot faster,” says Huang about the findings.
In the latest Intergovernmental Panel on Climate Change risk assessment, it says more frequent climate-related disasters are expected. This includes increases in the frequency and intensity of heatwaves, floods, fires, agricultural and ecological droughts, and intense tropical cyclones and hurricanes, to name a few effects world-wide. The map in the authors’ paper shows the climate-related risk in parts of the U.S that are home to significant economic activity, such as Florida, Texas, and California.
“Supply chains are important for firms’ performance, but idiosyncratic shocks such as natural disasters, cyberattacks, trade wars etc. threaten their stability and survival,” write the authors. Their findings are part of a climate adaptation solution. Supply chains can become more stable when natural disasters occur because affected firms use trade credit to increase the value of the relationships along the chain. For supply chain stability, generosity pays off.
The paper “Trade Credit and the Stability of Supply Chains” is a working paper authored by Ruidi Huang of Cox School of Business, Southern Methodist University, Nuri Ersahin of Michigan State University, and Mariassunta Giannetti of Stockholm School of Economics.
Written by Jennifer Warren.