Hypotheses, identification strategy and data 1 Literature and hypotheses

Previous literature have investigated how legal reforms that expanded pledgable asset categories could change firms‟ access to bank credit, asset composition, resource allocation, and industry composition. Campello and Larrain (2015) investigate the reforms in Eastern Europe that permitted the use of movable assets (e.g. machinery and equipments) as collateral, and find that such reforms promoted access to external finance, and reallocated assets and employments towards firms with more movable assets. Aretz, Campello and Marchica (2015) analyze the reform of the Napolenoic Code in France, and find that increased access to collateral – by expanding it to hard assets – increased firms‟ debt capacity and prolonged debt maturity. Cerqueiro, Ongena and Roszbach (2015) examine legal reform in Sweden that reduced the value of collateral (e.g. floating liens). They show that such reform reduced debt capacity and shortened debt maturity, and eventually contributed to distortions in corporate investment and asset allocation. Love, Martinez Peria and Sandeep (2016) investigate the effects of the existence of collateral registries on access to finance across a large number of countries. Calomiris et al., (2017) demonstrate that in countries with weak movable collateral laws, lending is biased towards loans backed with immovable assets, and resource allocations across sectors are distorted towards immovable-based production and investment. In general, these studies support the view that the expanded capacity of collateralization and better

80 _{Source: Independent Evaluation of the IFC Secured Transactions Advisory Project in China (2011) and Credit Reference}

157 enforceability of secured contracts facilitate firms‟ access to bank credit. However, this literature primarily focuses on accessibility to bank credit, while the effects of collateral law on alternative financial channels have largely been left out. In particular, some firms that had better access to bank credit due to weak collateral law served as non-financial intermediaries and redistributed their bank credit to their customers via trade credit. Having better collateral law could promote more direct financing from banks for those who relied on trade credit, which implies less demand for trade credit, and consequently less redistribution of bank credit through firms. These are potentially important effects of collateral law that have largely been ignored in previous studies.

Indeed, firms obtain credit from financial institutions as well as from other firms via trade credit. Burkart and Ellingsen (2004) provide one of the first theoretical models that explain that when banks ration credit, suppliers are often better positioned to provide credit. The suppliers extend trade credit because they have an advantage to overcome moral hazard and asymmetric information frictions with respect to banks. Moreover, suppliers obtain a markup on trade credit over their funding costs, making the extension of trade credit profitable from the suppliers‟ perspective. Suppliers may also extend trade credit because they have implicit equity stakes in their customers, and therefore willing to help financially constrained customers to overcome financial difficulties. From the borrowers‟ perspective, Petersen and Rajan (1995) find that, when confronted with bank lending constraints, firms are more inclined to borrow more expensive trade credit provided that investment returns exceed the cost of funding. Recent empirical studies have largely confirmed that accessibility to bank credit determines the supply and demand of trade credit. Garcia-Appendini and Montoriol-Garriga (2013) investigates how a negative shock to bank credit caused by the global financial crisis affects demand and supply of trade credit. They find that liquidity-rich suppliers can extend more trade credit during the financial crisis when external finance is difficult to access. This finding supports the view that suppliers serve as liquidity providers

158 (Cuñat, 2007), and trade credit is a substitute to bank credit (Biais and Gollier, 1997; Burkart and Ellingsen, 2004). In addition, a few papers investigate firms‟ financing choices with respect to legal institutions. Demirguc-Kunt and Maksimovic (2001) find that trade credit is more prevalent in countries with worse legal institutions. However, these studies usually rely on cross-country heterogeneity in legal institutions, which makes it more difficult to control country specific factors that could have driven the differences in trade credit. Shenoy and Willams (2017) explore an exogenous shock to banking liquidity due to the implementation of the Interstate Banking and Branching Efficiency Act in the United States. They provide evidence that legal reform which promotes bank competition improve banks‟ liquidity. Consequently more bank liquidity allows suppliers to provide more trade credit. Likewise, the customers who have access to bank liquidity can rely much less on trade credit. Their findings suggest that although trade credit are credit transactions in between firms, the accessibility of external bank credit plays a crucial role in firms‟ decisions of trade credit.

Motivated by these studies, our study tries to answer the following questions: Firstly, if collateral law improves access to bank credit, would firms substitute plausibly more expensive trade credit with bank credit? Secondly, how does collateral law affect the provision of trade credit? Thirdly, how does collateral law change the “redistribution of bank credit via trade credit”, a practice where firms with easier access to bank credit redistribute their obtained credit to less fortunate firms via trade credit? Lastly, if collateral law changes the provision of trade credit, how do firms change their asset and debt compositions accordingly?

The Chinese financial system is particularly suitable for answering these questions. First of all, the main source of external financing in China is bank loan, while other funding resources such as equity market and corporate bond market represent only very small share of overall financing. Before 2007, the annual funds raised from equity and corporate bond markets represented less than 5% of GDP, while that from banks represented 90% of GDP.

159 Secondly, the Chinese banking sector is notorious for misallocating credit (Cull and Xu, 2005). State owned, politically connected, and large firms have preferential access to bank credit, while small and medium sized firms have difficulties in accessing bank loans. The lack of alternative financing channels implied that many Chinese firms have to rely on trade credit to finance their short term financing needs (Allen, Qian, and Qian, 2005; Ge and Qiu, 2007; Cull et al., 2009). Indeed, Cull et al., (2009) find for a sample of 100,000 large and medium sized Chinese industrial firms, accounts receivables ranges from 18% of total sale for private firms, and 36.5% for state owned enterprises. On average these figures are relatively higher than the 18.5% for the U.S. Compustat firms (Peterson and Rajan, 1997). Ge and Qiu (2007) investigates a smaller sample of survey data and reports that the accounts receivables and accounts payables represent 13% and 14% of firm assets, respectively. These figures suggest trade credit is important source of financing for Chinese firms. Lastly, as argued in the introduction and in section 3.2 in more detail, the passage of the Property Law provided an ideal exogenous shock on the quality of legal institution, which bears particularly importance on firms‟ choices of external financing.

We develop our arguments as below. First we look at the usage of trade credit. Following previous literature, collateral law that expanded pledgable asset type could improve firms‟ access to bank credit. In addition, according to the substitution view of trade credit and bank credit, improved access to bank credit reduces demand for trade credit, given that the latter is usually a more expensive substitute of bank credit (Biais and Gollier, 1997; Burkart and Ellingsen, 2004). Therefore, if the Property Law expands access to bank credit, the usage of trade credit should decrease disproportionally more for those who relied on trade credit financing before the reform, and consequently, those firms could substitute more their financing needs with short-term bank credit. To further establish the causal relationship between accessibility of external financial resources and the substitution between trade credit and bank credit, we explore firm heterogeneity in financial constraints. If as argued that the

160 Property Law increases the availability of bank credit, it is expected to affect more financially constrained firms, in the sense that these firms should reduce more their reliance on trade credit and substitute more to short-term debt. In summary, we derive our first hypothesis:

Hypothesis 1: The Property Law should allow trade credit dependent firms to substitute their