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. 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.

This financial transmission channel will strongly matter in the months to come. Indeed, during the last two years, firms recorded very low level of insolvencies compared to what could have been expected in such a macroeconomic background. Government-backed loans in advanced economies have allowed sustained liquidity flows to companies which would have entered into bankruptcy otherwise.

Nonetheless, those government support measures are now coming to an end as dates of first repayments are approaching. At the same time, rising inflation has led major central banks (Fed, ECB, BoE) to tighten their monetary policies and raise their key interests rates, a first in a while. This change in monetary conditions – which will in all likelihood be drastic as inflation has proven to be more entrenched than initially expected – will affect overall financial conditions all around the world.

In particular, firms will have tougher access to external financing and pay more to get credits, making it harder to rollover their debt and ensure their liquidity position. This comes at a time when firms also have to face a strong increase in input costs, driven by the global rise in commodities prices and supply shortages. Depending on the sectoral competitive intensity and their own market power, some firms may prefer cutting their profit margins instead of rising their selling prices, thereby degrading their financial statements. Because of this combination of factors, firms’ financial sustainability is likely to be heavily affected in the short run. This means defaults are more likely to materialize going forward, and monitoring processes will be key to prevent series of default.

Because they involve highly sensitive financial data, financial interactions are too often forgotten in global vulnerability assessments. Nonetheless, identifying such interactions can prove very useful. Using Coface data on inter-firm trade credit and defaults in Western Europe, recent research1 identified key interactions across sectors that improve the short-term prediction of financial distress in a sector compared to what can be anticipated using macroeconomic tools. It appears that, after controlling for the macroeconomic outlook, monitoring financial health in a sector involves monitoring financial distress in production-related sectors over the last quarters.

Depending on sectors, such cross-sector interactions can bring key additional information compared to what macroeconomic monitoring can provide. To predict financial health in real estate activities, ICT, construction and IT services, past information on financial distress in productionrelated sectors will bring valuable information. The same research has shown that among those cross-sector interactions, cross-country relationships dominate. From there, we can conclude that cross-sector networks can explain parts of existing interdependencies across countries, which are not fully captured by country-level indicators.

1 Mélina London. Cross-Sector Interactions in Western Europe: Lessons From Trade Credit Data. 2022. (hal-03667832)

Finally, some sectors also appear to be key information providers for the rest of the considered Western European economies, with their level of financial health predicting financial distress in many other sectors. Those sectors are construction, wholesale and retail, chemicals and the automotive sector. They should be monitored in priority to anticipate widespread financial vulnerabilities1 .

1 For more details on those results, see: Mélina London. Cross-Sector Interactions in Western Europe: Lessons From Trade Credit Data. 2022. . (hal-03667832) Such results provide a first direction to improve monitoring processes to respond to the rising level of risks. Production and financial spillovers will be driving most of the aggregate impact of current shocks, explaining how current events are likely to have significant consequences in the coming quarters, if not years. A lot of uncertainty remains on the magnitude of the shocks, depending on next developments, especially when it comes to geopolitical tensions and Covid-19 pandemic. Nonetheless, when facing such uncertainty, up-to-date monitoring process will be crucial to react quickly. Including a network component in any future vulnerability assessment, both in production and in financial terms, can provide a first set of solutions.

Loss Given Default (LGD) working group is open for new members!

After the successful conclusion of the previous instalment of the LGD study on trade credit insurance, we are re-starting the project to establish an LGD for the year 2017, 2018 and 2019.

LGD stands for “Loss Given Default” and aims to give guidance on the proportion of a loss in relation to granted credit insurance commitment when a buyer defaults on a portfolio basis. This is of great importance for capital modelling of insurance and reinsurance undertakings. It is equally useful for reinsurance buying decisions for ceding companies and excess of loss pricing for reinsurers.

A public version of the latest report may be found on by following the following link.

Participation to the data gathering phase is open to all primary insurers, independent of ICISA membership. All data will be gathered and processed under strict privacy rules in cooperation of the Versicherungsforen Leipzig. The processed data is fully anonymized. All data suppliers will receive the full resulting report including loss distribution free of charge. Other ICISA members will be charged at cost.

For participation to the data gathering phase of this project, please contact us via secretariat@icisa.org.