The Importance of Trade Credit and Its

The Importance of Trade Credit and its

Mysterious Absence from Microfinance:

Recommendations for the Microfinance Community

Jessica Droste Yagan

Heather Franzese

May 15, 2006

Abstract

Despite the fact that its role is rarely officially recognizedby traditional microfinance institutions (MFIs) or their multinational supporters, trade credit has a significant presence among financing options for low-income consumers and micro-entrepreneurs. In this paper, we summarize existing information about the scope and characteristics of the major types of trade credit – consumer credit, supplier credit, and buyer credit – and begin to draw some preliminary conclusions about the impact of trade credit on the poor using that existing research as well as interviews with microfinance practitioners and experts (see Exhibit A for the list of interview questions and Exhibit B for the list of interviewees). Finally, we identify four recommendations for the microfinance community, including MFIs, international donors, NGOs, and companies that serve poor clients. We hope that these recommendations will spark an ongoing discussion about the emerging and potential relationships between MFIs and trade credit.

Defining trade credit

According to Fafchamps, “trade credit is a form of short term financing that is linked to the purchase of goods.”[1] The two most common types of trade credit are consumer credit – also referred to as store credit, installment credit, or hire purchase credit – and supplier credit. The former refers to consumers receiving goods on future payment, and the latter to suppliers offering goods on future payment. A less common but growing form of trade credit is buyer credit which is provided primarily to agricultural micro-entrepreneurs by their purchasers to ensure financial stability until harvest.

Trade credit exists primarily to promote profits: filling a financing gap for individuals to purchase consumer goods or for micro-entrepreneurs to purchase supplies helps both parties.[2] This dual beneficiary model has catalyzed retailers, suppliers, and buyers to create increasingly more innovative ways to address the financing needs of the poor.

Evidence of the widespread use of trade credit

While it seems there is very little widespread notice of and no comprehensive studies on the strength of trade credit in microfinance, we can summarize sufficient evidence from specific countries and regions to demonstrate its ubiquitous role (although not enough to distinguish the magnitudes of the various types).

Latin America: In 2001, 17% of Nicaraguan homes had store credit, the number one type of credit named by survey respondents, representing a growth of 6% from 1998 in a climate where other forms of credit did not grow.[3]

In 2002, microfinance experts in Brazil[4] blamed the underdevelopment of their microfinance industry in large part on store credit, “a major indirect substitute to microfinance,” and supplier credit, “used extensively across businesses of all sizes. . . [and] one of the most commonly used forms of financial services among microentrepreneurs.”[5] Stores often state payment terms for installment credit in advertisements, and most accept post-dated checks as a form of store credit (post-dated checks were used in 36% of all transactions in April 1998).

The success of two specific trade credit programs in Latin America also demonstrated its acceptance: Casas Bahia in Brazil and Cemex in Mexico. Casas Bahia[6] is the largest retail chain in Brazil, offering electronics, appliances, and furniture. Its business strategy was built around the belief that the only thing keeping the poor from buying goods was financing and today 90% of sales volume is financed. In fact, other consumer goods companies in Brazil have been forced to offer financing options to compete.

Cemex is the largest cement company in Mexico and the third largest in the world. In response to the unmet demand of poor Mexican women for opportunities to save for housing, Cemex created the Patrimonio Hoy program which combines credit (in the form of concrete) and savings.[7] More than 70,000 Mexican families have taken part in Patrimonio Hoy.[8]

Africa: In 1994 in Kenya, 38% of small firms and 6% of micro firms reported using credit from suppliers, in comparison with 58% and 12%, respectively, offering credit to customers, and considerably fewer, 13% and 2%, for bank loans.[9]

A 1996 study investigating discrimination in lending in South Africa reviewed the importance of “hire/purchase” lending. It found credit agreements between consumers and retailers of consumer durables were the second most common formal financial product used by black South Africans.[10]

In 2003, 16% of the residents of Swaziland had store credit accounts, the financial product second only to membership in a savings club, which 19.5% claimed as a current financial product. Store credit was the most common financial product for other members of the respondents’ households (5.3%) and the most common past financial product (16.9%).[11]

India: In a 2000 study of economic growth and poverty in the Indian town of Visakhapatnam[12], it was found that the poor had begun to gain access to consumer durables in large numbers due to the development of an informal hire purchase industry. The movement was so powerful that the authors noted “the importance of this hire purchase credit system may represent a ‘reinvention’ of the traditional debt system.”

In India as a whole, declining costs of commercial credit led to a 13.6% increase from 2000-2003. This activity has been heavily skewed towards the South and West regions of the country, which together account for 70-80% of the financed consumer durables purchases.[13]

Characteristics of trade credit

Consumer Credit: Consumer credit interest rates seem to becompetitive with MFIs. Casas Bahia in Brazil charges an average interest rate of 4.13% per month.[14] Cemex charges 12% fees per weekly payment but those fees also pay for construction advice, storage of materials, and other services in addition to interest.[15] In Guatemala, installment credit requires only a 7% premium on average.[16] There is evidence of abuse in some cases (researchers found that with fees, effective store credit interest rates often exceeded South African Usury Act limits) but it appears to be uncommon.[17]

Default rates (if assuming accurate reporting by both sides) cover a wide range but also seem to be comparable on average. For instance, in Casas Bahia stores, default rates start at 16% in a new store and drop to only 8.5% in established stores.[18] Cemex claims a default rate of only .45% (but it must be noted that they require a minimum savings amount before extended credit).[19]

Users of store credit are poor individuals and families who have a strong desire for consumer durables but do not have enough cash at any given time to pay for those items up-front. They either do not qualify for existing financial services but have sufficient cash flow to support financing or they find existing financial service options to be less attractive than what stores are offering.

Suppliers of store credit are driven primarily by the desire to sell more goods, but also by the fact that the financing provision itself tends to be a high yield business relative to the margins on the goods themselves. In addition, even when defaults do occur for the companies, the goods themselves are often able to be reclaimed as collateral so it is much less risky.[20]

Supplier Credit: Supplier credit is typically offered for short-term periods, anywhere from 5-10 days up to 1-3 months. This characteristic supports the claim that supplier credit is offered not as a profit mechanism in and of itself but as a tool to facilitate additional core business transactions. In fact,according to interviewees in Peru and Brazil, many suppliers offer such short-term credit interest-free. Another advantage of supplier credit for borrowers is that, because they receive the goods before payment, they have the ability to confirm product quality.

In the agriculture sector, where the majority of the poor in developing countries earn their living, supplier credit is one solution to small-scale growers’ lack of access to affordable inputs. The NGO Action for Enterprise suggests that practitioners “promote supplier credit from input suppliers to exporters, who then supply inputs on credit to growers.”[21]

Evidence is mixed on whether supplier credit is used more frequently by the poorest micro-enterprises, because they lack access to other sources, or by small and medium-sized enterprises, because this type of credit hinges on reputation and trust. The smallest and poorest entrepreneurs may be less able to repay – or at least viewed as such. Findings from Ecuador, by the World Council on Credit Unions,[22] and from Peru, by USAID,[23] claim that supplier credit is typically reserved for more “upscale” micro-entrepreneurs. In Zimbabwe, manufacturing firms rely heavily on supplier credit, but the micro-enterprises, as opposed to small and medium-sized firms, have difficulty accessing supplier credit and are “twice as likely to give credit to their customers than to receive credit from their suppliers.”[24]

The presence of trust and an ongoing relationship reduces the need for collateral and reduces risk for the supplier offering the credit, but it may also represent a disadvantage for micro-entrepreneurs in two ways. First, entrepreneurs from minority groups may face discrimination or suffer more limited access because of their lack of social capital. In Kenya and Zimbabwe, researchers found evidence of ethnic and gender bias – specifically against blacks and women – in the provision of supplier credit for manufacturing (but not in credit from financial institutions).[25] They attributed this preferential access for certain groups to social connections of the micro-entrepreneurs rather than to discrimination per se.

Second, suppliers who offer credit can exert unbalanced power over the borrowers by threatening to stop delivery of or charge exorbitant prices for goods essential to the micro-entrepreneur’s business. In West Africa, nationalized textile companies (such as CMDT in Mali) force cotton producers to purchase expensive pesticides and fertilizers that keep growers in a cycle of debt.[26]

Buyer Credit: Buyer credit is particularly crucial for small farmers. The traders, wholesalers, processors, exporters, and importers who buy the farmers’ products provide bridge financing for cultivation and family financial needs until harvest time. It allows the buyers to control product quality and to build loyalty and long-term relationships, and is fairly safe because the credit is often collateralized by purchase contracts.[27] This can be a great benefit to small-scale growers with no other credit options, but like supplier credit has its disadvantages including dependence on a few buyers or traders, and unfavorable terms.

Recommendations

Although we initially explored trade credit as it is manifested in the three different forms of consumer credit, supplier credit, and buyer credit, our main takeaways apply to the field more generally. Our four recommendations are: (1) pay more attention to trade credit, especially as it pertains to existing clients; (2) encourage pro-poor trade credit and credit bureau development; (3) protect clients from predatory trade credit through relationship brokering and education; and (4) seek opportunities to learn from and partner with trade credit providers, offering microloans to replace buyer credit where appropriate. We will explain each of these recommendations in turn below.[i]

Pay more attention to trade credit in general

Interviewees agree that key players in microfinance pay little attention to trade creditand, where they do, it is usually in regard to its role in precipitating over-indebtedness of clients. Those closest to the clients (e.g. loan officers) are definitely aware of it because they are in the community, talking to their clients, and checking clients’ backgrounds. Loan officers from the Mann Deshi Mahila Sahakari Bank in India, for instance, check with local shopkeepers to see if an applicant has outstanding debt there before approving a loan.[28] Not all MFIs verify sources of debt in this way, though, and there is an incentive on the part of the borrower to under-report.

There is also agreement among interviewees that trade credit is not often discussed above the loan officer level of the microfinance community; it is rarely taken into account when locating MFI branches or in designing MFI products, for instance. There are mixed opinions about why this is the case. One explanation is that it does not fall into the purview of microfinance because it does not involve finance institutions, which are commonly considered the only domain of true microfinance. One respondent said there is a perception in the development field that consumer credit in particular is “not as pure as producer credit” and “not of development value.”[29]Another theory is that it is toocomplex to track and understand so not worth the effort.

Despite these excuses for the field as a whole, interviewees consider trade credit to be a very relevant issue. One stated, “We have to tap into [trade credit], work with it,”[30] and another, “MFIs would be well-served to understand their ‘competition’ and understand how their products meet unmet needs in this context.”[31] An organization that offers buyer credit for craft producers agreed, “I have wondered why we can’t engage micro-credit institutions to create capital instruments that would support this pipeline.”[32]Almost all of them shared a desire for the field to pay more attention to trade credit and hoped to see our research product.

There is no clear reason why trade credit should not be studied just as thoroughly as credit offered by financial institutions. MFIs compete directly with trade credit by providing entrepreneurs with funds to purchase inventory, farmers with funds to purchase inputs, and consumers with funds to purchase daily essentials or larger consumer products. The only difference is that trade credit is directly tied to the provision of goods. World Council of Credit Unions’ John Ikedasays that, although many MFIs would not see it this way, “A loan is a loan. Consumer credit for a portable stove is not much different than a microloan if the stove is used for a small business to sell street food. Consumer credit is just not tracked.”

In some cases MFIs may find that they have difficulty competing because traders (retailers, suppliers, or buyers) offer products that are serving clients’ needs in fair and innovative ways or, in the case of agricultural credit, because MFIs lack the appropriate skill set to provide this type of finance. In other casesMFIs will find that they need to step in to help clients access trade credit orto prevent clients frombeing taken advantage of. A representative of USAID sees microfinance as a way to replace exploitive middlemen: “Many would say that the standard working capital loan is a replacement of the trade credit arrangements between middlemen and sellers.”[33]

The microfinance community should monitor trade credit more closely as it relates to their core business. Before deciding to fund expansion to new regions or new products, donors and MFI directors should understand what is being offered by traders. This will allow those focused on sustainable business growth to execute more effective long-term strategies and, for those driven by an altruistic mission to improve financial services for the poor, to focus attention and services on the areas and people that need them most.

Encourage pro-poor trade credit and credit bureaus

There are different types of trade credit, some beneficial for the typical microfinance client profile and others not. In cases where the poor are being served well by trade credit, in a way that is in line with the mission of microfinance, it may be more efficient for MFIs to encourage it rather than compete with it. As World Bank Rural Finance Advisor Renate Kloeppinger-Todd stated, “much of it works well without any donor intervention.”[34]

In particular, when large, established retailers offer credit to consumers it is usually at competitive rates and has features that are appealing to clients like ease of use or longer repayment periods.[35] One of the reasons those retailers can offer lower rates is that each purchase creates an asset automatically and directly tied to the loan as collateral. Elektra, an appliance retailer in Mexico, became so proficient at offering credit to its poor customers that it decided to convert its consumer credit division into a formally regulated bank for the poor called Banco Azteca.[36]

Traders can also offer specific knowledge and technical assistance with the loan disbursement and collection process. For instance, Cemex’s Patrimonio Hoy program involves home-building advice and storage solutions in addition to loans in the form of cement and other building materials. (It was conceived in part based on microfinance theory and many MFIs have contacted Cemex with positive feedback).[37]