Why Has the Nonfinancial Commercial Paper Market Shrunk Recently?

The total volume of nonfinancial commercial paper outstanding peaked in the fall of 2000 and has declined rapidly ever since. By September 2002, the market had shrunk more than 50 percent. Relative to historical patterns, both the magnitude and the timing of the decline are unusual. The decline is the largest on record, and the market started to shrink before the recent recession began. In the past, the volume of commercial paper outstanding tended to increase during the early stages of recessions.

Commercial paper is an important source of external funding for corporate borrowers and has become increasingly popular over the years. In 1966, the volume of nonfinancial commercial paper outstanding was typically less than 0.5 percent of bank loans to commercial and industrial borrowers. Since then, growth in the commercial paper market has averaged more than 20 percent per year, compared to an average rate of only 7 percent for bank commercial and industrial loans. And despite the recent dramatic decline, the volume of commercial paper outstanding in September 2002 was still about one-sixth of bank commercial and industrial loans.

This article investigates the factors contributing to the dramatic decline in the commercial paper market and assesses whether the recent shrinkage is likely to continue. The article begins by documenting the recent sharp decline in the volume of non financial commercial paper outstanding and contrasts this development with historical experience. The second section considers the factors that may have reduced the supply of credit in the commercial paper market, and the third section discusses the factors that may have reduced the demand. The article concludes that declines in both supply and demand have contributed to the shrinkage of the market. Looking forward, although the demand factors are waning, the supply factors are likely to persist in the near term and keep the commercial paper market under pressure.

I. THE SHRINKING COMMERCIAL PAPER MARKET

Nonfinancial commercial paper is short-term unsecured debt issued by nonfinancial corporations, typically large industrial or service firms and utility companies. Financial commercial paper, in contrast, is issued by financial companies, such as banks. This article focuses on nonfinancial commercial paper. For simplicity, nonfinancial commercial paper is referred to only as "commercial paper," and the commercial paper market is referred to as "the market." Appendix 1 provides an overview of the commercial paper market.

Commercial paper represents an important source of short-term funding for firms with very high credit ratings because it is one of the cheapest sources of external funding available. For example, the interest rate paid on 30-day commercial paper is usually comparable to the federal funds rate. The market, however, has shrunk considerably in the past two years. At its peak in November 2000, the total volume of commercial paper outstanding was about $351 billion. By September 2002, the volume outstanding had dropped more than 50 percent, to about $159 billion, its lowest level in almost eight years (Chart 1). (1) This unusual decline is the largest on record. In the previous five episodes of recession-related market shrinkage, the largest reduction in volume outstanding was about 27 percent.

This dramatic decline reversed a period of rapid growth in the issuance of nonfinancial commercial paper. After a few years of hesitant growth coming out of the recession of 1990, the commercial paper market grew robustly in the late 1990s. For the four years before its peak in 2000, the volume of commercial paper outstanding grew an average of about 18 percent per year, compared to an average yearly decline of roughly 35 percent over the last 22 months.

In addition to declining so rapidly, the timing of the current market's decline has also been unusual. Historically, commercial paper borrowing has usually expanded in the early stages of a recession and only started to decline when the economy was well-into recession. Chart 2 plots the volume of commercial paper outstanding around recessions, from six months before to 18 months after the start of each recession. The volume outstanding in the first month of each recession is normalized to 1 so that the changes during different recessions can be compared. The dashed line shows the average volume of commercial paper outstanding across the four recessions that occurred from 1969 to 1981. The grey line is the volume of commercial paper around the 1990 recession. The solid black line is the volume for the recent recession.

The current shrinkage differs dramatically from historical patterns. For each of the pre-1990 recessions, the commercial paper market grew substantially in the early stages of the recession and typically started to shrink about 12 months into the recession. During the 1990 recession, the pattern was similar, but the magnitudes of both the early growth and later decline were smaller. The market continued to grow after the recession started, just as in the past, but the growth was relatively weak and short-lived. In sharp contrast, the rapid shrinkage in the current market started four months before the onset of the recent recession.

What caused the market to shrink so rapidly and so early? The factors that may have contributed to the recent shrinkage can be separated into two groups: those affecting the supply of credit in the commercial paper market and those affecting the demand for credit in the market. The next section focuses on the factors that may have reduced the supply. The following section focuses on factors that may have reduced the demand.

II. FACTORS REDUCING THE SUPPLY OF CREDIT

Generally, the supply of funding for commercial paper depends on investors' willingness to participate in the market. This willingness can be lessened by two factors. One is the actual or perceived deterioration of the creditworthiness of borrowers who were previously considered to be of the highest quality. This factor usually causes a reduction in credit supply only in the commercial paper market. …

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