Managing Liquidity in Production Networks: The Role of Central Firms
Janet Gao
Review of Finance, Volume 25, Issue 3, May 2021, Pages 819–861, https://doi.org/10.1093/rof/rfaa025
In the U.S. economy, firms are closely connected in a production network and are exposed to the spillover effects of negative shocks from their connected firms. Recent research suggests that even small, idiosyncratic shocks can generate system-wide fluctuations. However, prior studies have largely overlooked the stabilizing role of firms’ liquidity management policies. I propose that firms central to the production network could potentially decelerate the propagation of shocks by conserving liquidity.
Central firms operate in sectors whose production depends heavily on other sectors. As micro-level shocks travel through inter-sectoral connections and form aggregate swings, they should generate a greater impact on firms in central sectors. By holding more cash, central firms can fare better during economic downturns. Cash reserves not only help firms sustain production during downturns, but they also allow firms to provide liquidity to customers and suppliers, whose survival is key to firms’ own productivity.
I construct a production network based on the 1997 input-output table provided by the Bureau of Economic Analysis. Firms’ centrality is defined as the eigenvector centrality of their industry in the production network. Centrality proxies for a sector’s dependence on the supply of input and the purchase of output by all other sectors, including those connected by higher-order linkages. It thus captures the sector’s exposure to all shocks that originate and propagate in the network.
I first show that firms in central sectors are more exposed to aggregate shocks: their investment and profitability are significantly more sensitive to business cycles than non-central firms. Central firms also have higher equity betas. Importantly, central firms maintain higher cash holdings than non-central firms. This effect is not explained by other determinants of cash, such as external financing frictions, firm governance quality, or multinational firms’ tax avoidance. Instead, it is consistent with central firms building up liquidity in anticipation of future aggregate shocks. Investors price-in central firms’ systematic risk by charging higher interest rate spreads on bank loans. Such a spread differential widens during economic downturns, potentially enhancing central firms’ incentives to hoard liquidity ex ante.
I look into firms’ trade credit usage to verify economic mechanisms. First, I examine whether trade credit allows firms to share liquidity and alleviate supply-chain shocks. Using the 9/11 terrorist attacks as an exogenous, negative shock to the airline industry, I find that suppliers increase receivables to provide liquidity to airlines. Suppliers with low cash reserves prior to the attacks further increase their payables, requesting liquidity from firms further upstream. Second, I show that central firms extend more trade credit during aggregate downturns, which is consistent with central firms “protecting” other firms during bad economic conditions.
This paper is the first to study firms’ liquidity management policies in relation to their production network centrality. It bridges a gap in the literature by proposing that systematically important firms in the economy conserve liquidity to preempt aggregate shocks.