June 2022 | The ICISA INSIDER
| Insights
Production and Financial Networks: A New Kind of Monitoring Tools in an Era of Financial Vulnerability By Mélina London, Economist at Coface
Today’s production mainly takes place on a globalized scale, following the extension of global value chains over the last decades. However, recent events have questioned this organization of production. News stories have repeatedly shown how one weak link in the chain could endanger the whole production process. Because firms in Western Europe use inputs from China in their production at home, disruptions in China can fully endanger manufacturing activity in Europe, as observed at the start of the Covid pandemic.
The closure of automotive plants in 2021 in Europe – as the result of electronic chips shortages in Taiwan – is only another example of such propagation of disruptions. The position of the weak link in the global value chain is crucial in this propagation. The closer a firm is to the end of the value chain, i.e. downstream, the higher is its vulnerability to supply shocks. Indeed, shocks will propagate, with an amplification at each step if upstream parties do not have the correct buffers to face the shock. The magnitude of the Russo-Ukrainian war fallouts reflect the importance of the shock position. Because both Russia and Ukraine produce many raw materials upstream in the value chains, the war is affecting a wide diversity of sectors. These fallouts add to existing pressures on each link of the value chain, in a domino effect. While it is impossible to be fully shielded from those shocks given the current structure of production and required skills at each step of the process, firms should be able to improve their vulnerability assessment through the identification of such production links and resulting interdependencies. Building adequate buffers will require a global strategy of diversification, involving all actors in the value chain.
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However, these production links are only part of the problem; one side of the coin. Besides their interdependence in terms of production, firms also often provide credit to one another to finance their trade flows. Under these specific terms of trade, suppliers provide credit to their buyers by financing the production of goods or service and allowing them to defer payments. By doing so, they interlock their balance sheets to their partners’ ones. Trade credit appears as an asset for the supplier and as a liability for the buyer. This creates an additional source of vulnerability on the financial front. Suppliers depend on their buyers’ repayments to fulfill their own trade credit obligations to their suppliers. A reduction in trade credit provision upstream in the chain is likely to cause lower trade credit agreements in the rest of the global value chain. Only in this framework can we understand the global consequences of Thomas Cook’s bankruptcy in September 2019. When the main British tourism agency entered into bankruptcy, financial distress propagated to its suppliers because of the importance of Thomas Cook as debtor, leading to a series of defaults of firms that could not compensate for the losses and passed the default to their own suppliers.
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