Impact of Commercial Paper in the Indian Money Market

In today’s competitive environment, firms find themselves in a perpetual race to acquire the cheapest source of finance to leverage their companies and gain a competitive advantage. All this is undertaken by companies to satisfy their masters – the shareholders. Finance is a very scarce commodity. A company can satisfy its funding needs generally through two sources namely, equity and debt. It is common practice to use a mix of both in the capital structure. Further the company may rely on two sources of finance – long term sources and short term sources. Long term sources of finance typically include – Shares, debentures, venture capital, public deposits, government grants, mortgage, retained profits, loans from financial institutions, loans from commercial banks etc. Whereas, short term sources of finance include – Overdraft, trade credit, factoring, cash credit, loans & advances, discounting of bills, commercial paper etc.

A very interesting segment of finance to note is that of money markets. It is an important component of financial markets and is a short term market with maturity period of 1 year or less. The most common instruments traded in the money markets include –treasury bills, certificates of deposits, repurchase agreements, commercial paper (CP) etc.

Commercial paper is a short-term debt instrument of the money market. It is an unsecured promissory note with a fixed maturity of 7 to 365 days. It is issued at a discount and redeemed at par. The origin of commercial paper can be traced back to the late 19th century when it grew rapidly as a source of corporate financing until 1920s when it all but disappeared during the Depression. Momentum picked up after the Second World War and a notable incident in the commercial paper market was the Penn Central [1] failure which shook the market and temporarily halted its growth (Calomiris, Himmelberg, & Wachtel, 1994). Commercial paper as a source of short term funds to Indian corporate sector was introduced from 1990 by the then government in the process of continuing reforms. The direct objective of commercial paper was to improve the short-term liquidity. That is by releasing the pressure on bank funds for medium sized borrowers and enabling companies with high credit ratings to raise funds directly from the markets (Reddy, 1999).

Commercial paper can be further categorized into financial and nonfinancial commercial paper. Nonfinancial commercial paper is issued by nonfinancial corporations, typically large industrial or service firms and utility companies. Financial paper on the other hand is issued by financial companies such as banks (Shen, 2003).

From the investor’s point of view, commercial paper carries with it a great many advantages like – low risk due to issuance by prime rated companies, limited reinvestment risk because the commercial papers are generally issued for a short time horizon thereby protecting the investor from large interest rate fluctuations. Investors are also keen on the fact that commercial paper gives higher yields when compared to other short-term investments such as treasury bills or certificate of deposits (Standard & Poor’s, 2008).

On the flip side commercial paper is not absolutely risk free, there are certain risks attached to commercial paper – credit risk in that the company may be unable to pay the investors on maturity though this is an extremely rare event, interest rate risk which arises due to the changes in the market interest rates. This risk is mitigated because most commercial papers are issued for short term and most of the investors hold onto the paper until maturity thereby they are unaffected by price movements. Rollover risk is also present because most papers are retired by the companies by making a fresh issue. This risk is also minimized by securing a bank line of credit. The major risk facing commercial paper is liquidity risk which affects the market as a whole. The whole market turns hostile, interest rates rise and the issuer becomes unable to rollover or make fresh issues (Standard & Poor’s, 2008).

To guide the investors in making rational and informed decisions, it is mandatory for the commercial paper issue to gain a credit rating from recognized agencies. Ratings give an idea as to the risk attached to the commercial paper and the overall picture of the firm. A substandard rating implies that the firm is extremely risky and there is probability that the firm may default on its payment. In U.S., the recognized credit rating agencies include Standard & Poor’s, Moody’s, Fitch, A.M. Best etc. In the commercial paper rating mechanism practiced by Standard & Poor’s, a rating of ‘A1+’ is the highest possible score meaning that the firm is creditworthy and there is no risk of default whereas a rating of ‘A3′ and below notifies that the instrument is speculative or junk.

In India, Credit Rating Information Services of India Ltd. (CRISIL) and Investment Information and Credit Rating Agency of India Ltd. (ICRA) are the reputed rating agencies. The other notable agencies operating in India are FITCH ratings and Credit Analysis and Research Ltd. (CARE). According to the RBI, for a commercial paper to be issued in India the company must have a minimum credit rating of P-2 as per the CRISIL rating scale or its equivalent. Rating is extremely important as the regulations laid down specify that money market funds can invest only in commercial papers having the minimum rating of P-2.

Commercial paper scores over bank line of credit or short term loans in many aspects. A company that has high credit ratings enjoys many privileges – they can access lower cost commercial paper, flexible maturity periods to match their cash flow stream. Commercial paper in essence is an unsecured promissory note. Thereby, there is no lien created on its assets. Moreover, there is no limitation on the end-use of funds generated through commercial paper issue. They are traditionally favored as they are cheaper when compared to bank loan, as low as 3.5 % for three months & 5.6 to 5.75 % per year. Banks cannot match this rate since their cost of funds itself works out to almost 6% (Pathak, 2009).

Money market funds are the largest holders of commercial paper (Standard & Poor’s, 2008). The other investors in commercial paper include trust funds, retirement and pension funds, insurance companies and other large firms having extra funds to invest in them. Individual investors find it difficult to deal in this market because commercial papers are usually sold in very large denominations. To overcome this, they invest in it through money market mutual funds. In India commercial banks were the subscribers of almost 80% of all commercial paper issues but that trend has been declining and as in the U.S., mutual funds are becoming the prominent investors.

The recent financial crisis affected almost all the major economies around the globe. The U.S. was the epicenter of this financial earthquake. The recession had far reaching effects – many companies folded, investment houses lost their prominence and were absorbed by larger entities and banks were bailed out by the government to avert an economic disaster. The commercial paper market first felt the effects of the crisis on August 2007 when the market contracted sharply as a reaction to the subprime crisis (Shrivastava, 2008). The crisis deepened during September 2008 beginning with the default of Lehman brothers. A large money market fund, the Reserve Primary Fund announced that it had suffered losses to the tune of $785 million as a result of holding Lehman Brothers’ commercial paper. This spread shockwaves through the entire market and investors were in a hurry to redeem their holdings. In a space of one month the total value of commercial paper outstanding reduced by 15% from $1.76 trillion to $1.43 trillion (Kacperczyk & Schnabl, 2009).

The Indian economy is intimately tied to the global economy; as such any fluctuations in the global market will have repercussions in the Indian financial market also. Global financial crisis manifested itself in India on January 2008 resulting in the crash of the Indian stock market caused due to the fleeing of FIIs (foreign institutional investors). The Indian commercial sector found itself in a race to acquire funds due to the drying up of several avenues of fund notably, external commercial borrowing. To counter this, bank finance in the form of investments in shares, bonds, debentures, commercial paper etc. expanded more than the previous year (Joseph, 2009). So on a contrast with the commercial paper market of America, the commercial paper market in India was on a rise during 2007.

In the U.S., the Federal Reserve undertook unprecedented steps to stabilize the commercial paper market. Federal Reserve of New York introduced the Commercial Paper Funding Facility (CPFF) whereby the Federal Reserve would buy the paper directly from eligible issuers (Federal Reserve, 2008). In early January 2009 the Federal Reserve was the single largest purchaser of commercial paper and accounted to having almost 22% of the market. The facility purchases the commercial paper and holds onto it till maturity and the returns received upon maturity are utilized to pay off Federal Reserve of New York which had provided the capital to initiate the facility. At its peak the Federal Reserve held almost $357 billion worth of commercial paper, that holding was gradually reduced over the years and at the time of the withdrawal of the facility during February 2010, the amount had dwindled down to $3.94 billion (Zumbrun, 2010). In India, the commercial paper market is extremely healthy and as per the latest outstanding figures it is 1,03,915 crores.

1.1 Aim of the project

To understand the role of commercial paper in the Indian money market along with the changes in risk & return and also the total outstanding during the period of financial crisis.

1.2 Need of the study

India is the second fastest growing economy in the world. The policy makers aspire to attain double digit growth rate. During our review of literature we came to understand that no significant study had been undertaken to understand the effect of the financial crisis on the returns of commercial paper in India. Moreover, studies concerning commercial paper on a global level are also limited. We attempt to fill this knowledge gap. There is wide literature in the form of articles regarding the effects of the financial crisis on the American commercial paper market. We are attempting to understand if the effects of recession on the American commercial paper market have also affected its Indian counterpart.

1.3 Objectives of the study

The following are some the objectives that we hope to accomplish during the course of our study.

a. To understand the role of commercial paper as an instrument in Indian Money Market.

b. To understand risk & return movement of commercial paper in India during the financial crisis.

c. Comparative analysis of risk & return between American & Indian commercial paper.

d. Understand the changes in commercial paper outstanding of both American and Indian commercial paper market during the financial crisis.

1.4 Hypothesis

There is a positive correlation between Indian & U.S. discount rates.

Indian & U.S. commercial paper outstanding have decreased during the period of financial crisis.

1.5 Methodology

The study is quantitative in nature. We will be relying exclusively on secondary sources of data, significantly the reports generated by the Reserve Bank of India. Statistical tools such as measures of central tendency, measures of variation and correlation will be used.

1.6 Limitations of the project

The major problem being faced is scarce information regarding the Indian commercial paper market.

Time constraint will limit the extent & depth of the study.

The data regarding commercial paper rates for both India and U.S. has been published only up to November 2009 at the time of study.

1.7 Chapter Plan

The following is a brief summary of the chapters within the project.

Chapter 1: Introduction – Provides a brief insight into the history, role and functioning of commercial paper as a money market instrument. This is followed by the aim, the need, objectives and a brief overview of the methodology followed by the limitations of the study.

Chapter 2: Literature review – A broad review of literature which was deemed relevant to the study. The literature mainly comprise of empirical studies undertaken by various researchers.

Chapter 3: Methodology and the methods – The data source, statistical tools are highlighted in this chapter.

Chapter 4: Analysis and Interpretation of the data collected. – Using the techniques mentioned in the methodology, a thorough analysis of the data is conducted. A brief interpretation is also provided.

Chapter 5: Conclusion – Concludes the study with a summary of our findings.

Chapter 2: Literature Review

2.1 According to Saurabh Ghosh and Narayan Chandra Pradhan (2009)

The authors have tried to understand the determinants of WADR (weighted average discount rate) and how these determinants have affected their movement over the past 5 years after adjusting for seasonal fluctuation. The real and financial variables considered for the study were: – Index of industrial production (IIP), Amount of CP issued, Cut-off yield 364 days, Call/Notice money, Sensex, Indian Rupees – U.S. Dollar exchange rate & bank credit. A close movement and dependency was found out between WADR and the call rate & the 364 day treasury bill yield. Although initially there wasn’t much co-movement between WADR and the BSE Sensex, co-movements were noticeable after December 2005.The empirical results indicate that there has been an increase in the average monthly issuance, WADR and volatility of WADR over the years. However, around 80% of the commercial paper issued by companies over the last five years was from ‘Prime-rated’ companies.

2.2 According to Matthias Kahl, Anil Shivdasani & Yihui Wang (2008)

Firms access commercial paper market to enhance their financial flexibility. Firms use it to fund investment when attractive projects arise and they have insufficient internal funds. Another way in which commercial paper may be used to increase a firm’s financial flexibility is as bridge financing. They argue that commercial paper borrowing in positively correlated with investment expenditures and negatively correlated with cash holdings.

2.3 According to Pengjie Gao and Hayong Yun± (2009)

The collapse of Lehman brothers was followed by a virtual closing of the commercial papers market, followed by which a number of firms drew excessively on their remaining lines of credit out of fear that weakened banks would reduce their loan commitments. Aggregate commercial paper borrowing declined 15% after the collapse of Lehman brothers, but the effect was concentrated among firms with high default risk. High risk borrowers that were negatively impacted by the decline in the commercial paper market after Lehman’s default substituted commercial paper with lines of credit. Low risk borrowers remained as they were.

2.4 According to Charles W. Calomiris, Charles P. Himmelberg & Paul Wachtel (1994)

The authors arrived at three conclusions. Firstly, there is a flight to quality during a downturn. Firms with strong balance sheets exploit this demand to reduce their cost of short-term borrowing. Secondly, firms in strong financial condition issue commercial paper during downturns in order to extend credit to other firms which may include customers of the firm. As the economy weakens, customers pay their bills more slowly and firms may extend more trade credit as a means of financing their customers’ short-term credit needs. There is evidence that commercial paper is used to finance trade credit. Finally, increased commercial paper issuance is used to finance inventories.

Further, they established links between growth of commercial paper in relationship between the paper market and the commercial bank portfolios. At various times the growth of the commercial paper market was attributed to –

(i.) Banks with weak loan demand that were searching for an alternative asset.

(ii.) Regulatory constraints that made bank deposits unattractive.

(iii.) Market conditions that made bank loans relatively expensive.

2.5 According to John P. Judd (1979)

The researcher argues that commercial paper market has replaced the banking sector as the primary source of short-term funds for large financially sound nonfinancial firms. Banks can compete effectively only if the value of the intermediate services that they provide to the lenders/borrowers is greater than the spread between the lending and borrowing rates that they must charge to cover the costs of doing business and absorbing risk. However, it was found that the value from the intermediate services were relatively small and hence the switch over to commercial paper.

2.6 According to Pu Shen (2003)

Before the current drop in commercial paper outstanding there was a past occurrence in 2002 when the market for nonfinancial paper declined rapidly. The author tries to understand the factors that led to the unusual decline. To achieve this he considered the factors that could have reduced the supply of credit as well as factors that could have reduced the demand in the commercial paper market. On the basis of this analysis, a conclusion was reached that both demand and supply contributed to the decline. Supply in this context means willingness of the investors’ to participate in the market. Willingness can be reduced by two factors – Actual or perceived deterioration of the creditworthiness of borrowers and general reduction in investors’ tolerance for risk. On the demand side, two factors reduce the need for corporations to borrow in the commercial paper market. One factor is decline in inventories which reduces companies’ short-term financing needs. The other factor is a switch by firms from borrowing short-term in the commercial paper market to borrowing longer in the bond market.

2.7 According to Dan Covitz & Chris Downing (2002)

A model is created to explain the relationship between short term and long term yield spreads. Short term spreads cannot be explained by insolvency model because of large spread. Many a times short and long term spreads are negatively correlated. Their explanation for observed risk spreads rests on a distinction between the fixed and liquid assets of a firm. A simple model was proposed in which a firm with a low level of liquid assets may be forced to turn to outside sources of funds to meet its short-term obligations. Funds raised from outside can bring in delay in payments to creditors, which can affect the short term creditors more than long term creditors. Variety of insolvency-risk and liquidity-risk proxies were used and was found that liquidity risk help explain short-term spreads during periods of market stress, but explains very little about long-term spreads. Their empirical findings indicated that while liquidity is an important determinant, the credit risk is the dominant determinant of Commercial Paper credit spread.

A literature survey regarding Asset Backed Commercial Paper (ABCP) was conducted, but was disregarded as it was not relevant to the research at hand. A working group has recommended that ABCP’s be introduced to deepen the commercial paper in India. Following this the RBI issued the draft guidelines on securitization of standard assets on April 4, 2005.

Chapter 3: Methodology

Research basically means a quest for knowledge. The primary purpose for applied research is discovering, interpreting and the development of methods and systems for the advancement of knowledge on a wide variety of scientific matters (Wikipedia.com).In this chapter the methodology and methods to be used for analyzing the commercial paper market are briefly discussed along with the problems encountered and the steps that were taken to overcome them.

3.1 Types of Data

There are broadly two types of data that are available at the disposal of a researcher.

3.1.1. Primary Data

We may rely on primary data if the research calls for raw data that has been collected at the source and has not been subject to any manipulation. Primary data can be qualitative or quantitative. The core benefit of this type of data is that the researcher can exercise a high degree of control over the method and tailor the data collection methods to suit the needs of his research.

3.1.2. Secondary Data

Primary data collected by one person may become the secondary data of another. Secondary data has many benefits that make it very appealing. The most obvious advantage is that the data is very economical since the cost of collecting it is usually very little when compared to primary data. It also saves the time of the researcher which would otherwise have been spent on the data collection process. Another key advantage is that in the process of searching for data relevant to the problem, the understanding of the researcher of the problem is improved and there can be changes in the idea in light of the secondary data collected (Beri, 2003).

That is not to say that there are no limitations to it. The major risk undertaken by the researcher when collecting secondary data is that the accuracy of the data is compromised. Subsequent problems may be the availability, relevance and sufficiency.

Our research relies on secondary data specifically the commercial paper rates published by the Reserve Bank of India and The Federal Reserve. Since these institutions are the apex central banks of India and United States of America respectively, we assume that the data provided by them is highly accurate and can be safely used in our study.

Internet Research. As the name implies, it is the practice of using the World Wide Web for research purposes. After identification of our topic, we had to undertake an internet research to gain more background information about it and further our understanding of the topic. Several newspaper articles published on the internet was used to draw a rough chronology of the events in both the Indian & U.S. commercial paper markets during the period of study.

3.2. Time Period

The financial crisis was well underway during the early half of 2007 due to subprime mortgages default. We have divided the time period of our study into two distinct frames to analyze and draw logical conclusions.

3.2.1 First Time Period (November 2007-October 2008)

We have selected November 2007 as the initiation point of the first time period our study due to the fact that the stock markets in America was in turmoil and falling rapidly. Leading up to this point there were certain major market developments, the LIBOR (London Interbank Borrowing Rate) reaches its highest level since 1998. Northern Rock collapses and receives emergency support from Bank of England. Major Banks such as UBS and Citigroup announce losses numbering in the billions due to subprime mortgage defaults.

September 2008 was a very dynamic and crucial month in the context of the financial crisis.

U.S. government bails out mortgage lenders Freddie Mac & Fannie Mae, which hold almost half of all outstanding mortgages in the U.S.

Bank of America proposes to take over Merrill Lynch for USD 50 billion.

Lehman brothers files for bankruptcy making it the biggest corporate bankruptcy ($ 639 billion) in the history of U.S.A.

Morgan Stanley & Goldman Sachs loses their status as investment banks. They become traditional commercial banks (Mauro F. Guillén, 2009).

The first time period concludes on October 2008. The reason we have selected this particular month is that in the aftermath of Lehman Brothers bankruptcy, the commercial paper market contracted severely. Investors lost their confidence and companies were finding it difficult to make fresh issues of commercial paper.

3.2.2 Second Time Period (November 2008-November 2009)

For companies that use commercial paper as a short-term funding mechanism, a sudden stoppage of access to the market will push them to the brink of bankruptcy. The Federal Reserve recognized this and initiated the Commercial Paper Funding Facility towards the end of October 2008. The major objective was to stabilize the commercial paper market and provide the necessary funding to the companies. Our second time period picks off from this point and continues till present.

3.3 Statistical Techniques

Statistics is termed as the science of making effective use of numerical data. It deals with all aspects of it including collection, analysis and interpretation of such data collected. To facilitate our analysis, we had to rely on certain statistical tools and the software SPSS.

3.3.1 Measures of Central Tendency

The most commonly used tool for understanding ‘averages’ is the arithmetic mean. A single value which is a representation of the entire mass of data taken into calculation. It is neither the highest nor the lowest value in the data set. It takes into account all the values in the study. It is in essence a single value around which the other variables in the study tend to cluster. The arithmetic mean is also laden with a certain disadvantage namely the tendency of the mean to get unduly affected by the presence of extreme values.

3.3.2 Measures of Variation

Using mean will only supply us with a single figure representing the entire data. We cannot understand the dispersion of the values from the mean. To overcome this obstacle, we need to use a measure of variation. We have decided to study the variation utilizing the tool ‘standard deviation’. Standard deviation helps us to measure the risk associated with commercial paper. Standard deviation will be equal to zero when all the numbers in the sample are very close to one another. The more dispersed they are the greater will be the standard deviation.

3.3.3 Correlation

Mean and standard deviation does not allow us to compare two different variables. In such a scenario we may use correlation to understand if any relation exists between two variables. If relation is proved, correlation further helps us to judge to what degree the relation is present and the significance of it. The correlation coefficient ‘r’ ranges from -1.0 to +1.0. The closer ‘r’ is to either poles, the higher the correlation. Towards +1 indicates a positive correlation whereas closer to -1 is an indicator of negative correlation.

3.3.4 Simple Bar Diagrams/ One-dimensional Bar diagrams

Simple bar diagrams are considered to be the most commonly used diagrammatic representation of data. Only the length of the bar matters, the width of a single bar is present only for drawing attention to the figures and making clear cut conclusions. We have used bar diagrams to depict the trend of commercial paper outstanding in both the Indian & U.S. commercial paper markets over the period of study.

3.3.5 Times Series Graphs

We have utilized time series graphs to chart the movement of risk across the time period of study. The reason for the selection of this technique is due to its usefulness in giving a quick idea about the trend of the variable over a period of time. The other added advantage is that it allows a comparison of two variables also across the time period.

Chapter 4: Findings & Analysis

4.1 Introduction

In this chapter, we attempt to make a systematic analysis of the secondary data that we have collected from Reserve Bank of India & Federal Reserve System. The raw data was transferred to Microsoft Excel software after proper scrutiny. The data was analyzed by using the statistical tools present in the Microsoft Excel & SPSS programmes. As we have described earlier in the methodology, descriptive statistics like standard deviation, arithmetic mean and inferential statistics like correlation were used to analyze the data. Data presentation tools like Simple bar diagram and Time series graphs were utilized to present the data logically and in an understandable manner.

The discount rates provided by RBI consisted of low & high rates. The average of the discount rates was calculated to make a meaningful analysis and enable comparison with the U.S. commercial paper discount rates, since the Federal Reserve provides only a single rate. Moreover in the U.S. the commercial paper market is sub-divided into two broad strata, i.e. financial and non-financial commercial paper. Both of these were taken into account to enable the study to be more comprehensive and significant.

The U.S. commercial paper outstanding amounts were converted into Indian rupees on the basis of foreign exchange rate prevalent in the time period of study. This was conducted on a month wise basis from November 2007 till November 2009.

4.2. Analysis of Data

The following section contains an analysis of the data.

4.2.1 The first analysis conducted was to trace the movement of discount rate in India during the first time period.

Table.1. Mean & Standard Deviation of Indian Discount Rate during November 2007- October 2008

Mean

10.9242

Std. Deviation

1.70208

Interpretation

68% of the time, the average discount rate shall vary between 9.6 and 12.6. That means for nearly 8 months of the study period, the rate of return of commercial paper in India will be between 9.6 & 12.6

95% of the time, the discount rate shall vary between 7.5 and 14.3.

The overall trend from the observed figures indicates forward direction. The cause behind this trend maybe the accelerated inflation rate. The investing community’s confidence levels are weakened, as a result the expected levels of discount rate also increases. Another reason may be that the investors are worried about the exposure of Indian banks to U.S. subprimes. For instance ICICI exposure to Citibank Asset backed securities is one important reason behind uncertainty in Indian money market segment.

Graph.1. Movement of discount rate during Period 1

Interpretation

Until December 2007, the discount rates did not undergo much fluctuation. From January 2008 till April 2008, the rates were subject to wide changes the average rate reached heights like 11.88 and depths of 8.73. In March, the market on expectations of a promising RBI credit policy announcement has shown an upward surge. But the RBI maintained the status quo, the bank rate, the repo rate and the reverse repo rate were unchanged. Following this the returns show a decline and thereafter it has shown a rising trend till October 2008. Corresponding to this period, the inflation rates in India had also been growing at an accelerated pace. The inflation in India during March was 5.11%, this shot up to 12.63% in August and declined to just 10.72% by October end. If the inflation rate increases, the nominal interest rates also increases, as a result commercial paper discount rate is also showing an increase.

The discount rate rose to an all time high of 14.23 in October 2008.This abnormal rise in discount rates may be linked to Lehman Brothers declaring bankruptcy in U.S.A. on September 15, 2008. Because of the bankruptcy, the investors have lost their confidence on money market instruments. This event might have triggered investors in the Indian commercial paper market to seek higher discount rates on the Indian commercial paper. As a result pushing up the discount rates on commercial paper issued by the Indian corporate sector.

4.2.2 This analysis deals with the movement of discount rate in