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^ ((/()'((/-reberwe /an A c/eve/antf : ECONOMIC R EVIEW /ff/y J970 A dditional copies o f the ECONOMIC REVIEW may be obtained from the Research Department, Federal Reserve Bank o f Cleveland, P. O. Box 6387, Cleve land, Ohio 44101. Permission is granted to reproduce any material in this publication providing credit is given. BANKERS' ACCEPTANCES The use and outstanding volum e o f d ollar bankers' acceptances increased sharply in the past decade. This grow th reflects the expansion in w orld trade and inter national credit flo w s during this tim e, since bankers' acceptances are p rim a rily used to finance international transactions. The outstanding volume o f this money m arket instrum ent rose fro m $1.2 b illio n at yearend 1959 to $5.5 b illio n at the close o f 1969. Most o f the grow th occurred in tw o d is tin c t subperiods, 1960-1961 and 1967-1969, w ith the determ ining factors d iffe rin g fo r each period. The nearly five fo ld increase in the volum e o f o u t standing acceptances in the past decade seems very impres sive u n til it is compared w ith the grow th in the volume o f other money m arket instruments. A fte r comparison, it is evident th a t the use o f dollar acceptances has not kept pace w ith other form s o f short-term financing in the United States. For example, from yearend 1959 to yearend 1969, the volume o f commercial and finance company paper rose nearly te n fo ld ; outstanding tim e certificates o f deposit clim bed, on balance, fro m less than $1 b illio n to $11 b illio n ; rose fro m E urodollar volume an estimated $2 b illio n (at the end o f 1960) to $40 b illio n ; and the size o f the markets fo r Federal funds and Federal agency issues IN THIS ISSUE increased more than five fo ld . Moreover, the outstanding volume o f bankers' acceptances in 1969 was substantially Bankers' Acceptances . . . . 3 smaller than the dollar amounts o f all other types o f money m arket A Note on the Current instrum ents w ith the exception o f repurchase agreements. A lthough the grow th in d ollar acceptances was Decline in less vigorous p a rtly because o f the specialized nature o f this Corporate P r o f it s ......... 12 instrum ent, other factors were at w o rk . This article describes dollar acceptances and recent developments in the m arket fo r this instrum ent. 3 ECONOMIC REVIEW FUNCTION OF ACCEPTANCES tim e d ra ft w ith his local bank, thus obtaining cash A bankers' acceptance arises from a short-term before the buyer (the United States im porter) has credit arrangement designed to enable businesses paid fo r the radios.1 The foreign bank w ould then to rem it the discounted d ra ft to the im porter's bank obtain actions. funds to finance commercial trans In recent years, an overwhelm ing pro in the United States fo r acceptance and discount. portio n o f acceptances has reflected the financing The accepting bank forwards the accompanying of foreign trade, as opposed to the shipm ent or documents to the im porter so th a t he may obtain storage of goods w ith in the United States. possession o f the goods when they arrive. The transactions acceptance may then be held by the accepting involving businesses in d iffe re n t countries and w ith bank as an earning asset— or it may be sold in the less w ell-know n credit standings; however, they are secondary m arket at the going rate o f discount fo r somewhat Acceptances are well-suited fo r in domestic commerce the specific m a tu rity. The im p o rte r must pay the because o f the docum entation th a t is required. bank before the acceptance matures, whereupon Generally, a dollar acceptance is a tim e d ra ft the bank liquidates the obligation. cumbersome Several advantages o f a dollar acceptance are drawn on a bank by an exporter or an im porter to obtain a stated am ount o f funds to pay fo r specific apparent merchandise or, less frequently, foreign exchange. exporter receives his funds p ro m p tly and thereby The d ra ft is then "accepted” by the bank (the avoids any delays th a t could result from extended drawee) that, in effect, un co n d itio n a lly guarantees shipping tim e. The exporter does not have to be to pay the face value o f the instrum ent on its overly concerned w ith the credit standing o f the m a tu rity date. The face o f the instrum ent specifies United States im porter, because a bank has guaran the dollar am ount involved, the m a tu rity date, and teed to pay fo r the merchandise. S im ilarly, the the nature o f the underlying transaction. Upon exporter does not have to be concerned about acceptance, foreign exchange costs and risks because his local the United States bank stamps fro m this sim plified example. The "accepted” and signs the face o f the instrum ent. bank pays him in domestic funds. In view o f these Most acceptances are short term in nature; th a t is, advantages, it is not surprising th a t dollar accep they have m aturities o f six months or less. The tances are ch ie fly used fo r overseas financing and short-term nature o f the instrum ent reflects the th a t they are freq u e n tly instituted by foreigners. tim e required to ship the financed merchandise and sell it in to trade channels. Because o f the highly specialized nature o f this financing, the creation o f dollar acceptances has In a typical transaction, a foreign manufacturer tended to be concentrated among the largest and m ight wish to sell a shipm ent o f radios to a United best know n banks in the United States (and th e ir States Edge A c t corporations), foreign banks, and United im porter. The im porter could ask his domestic bank to send the foreign exporter a letter States o f credit authorizing the exporter to draw a tim e institutions, m ainly in New Y o rk C ity and San agencies of foreign banks. About 170 d ra ft on the bank w ith a m a tu rity of, say, three Francisco, cu rre n tly report th e ir a c tiv ity to the months. A fte r gathering supporting documents, 1 such as bills o f sale, bills o f lading, and insurance o f the d r a ft, re fle c tin g th e b a n k ’s rate o f d is c o u n t and any papers, the exporter m ight sell or discount the fees and costs n o t absorbed by th e bank. The e x p o rte r w ill receive fe w e r fu n d s tha n th e face value JU LY 1970 Federal Reserve System. When created by this those used to finance merchandise stored in or group o f banks, dollar acceptances are shipped between foreign countries, and those used considered to be prime q u a lity money market to create dollar exchange. The la tte r acceptances instruments; fo r example, they are eligible to be are not associated w ith the shipm ent o f specific select used as collateral by banks when borrow ing from merchandise " b u t are designed to alleviate seasonal Federal Reserve banks2 and may be purchased by s h o rta g e s the Federal Reserve in the secondary market. countries,"4 especially Latin American countries. of d o llar exchange fo r certain The illustration given above can be m odified to Dollar exchange acceptances no longer serve their demonstrate the great fle x ib ility o f these financing original purpose, however, and th e ir use has been arrangements. severely lim ited in comparison w ith other accep the tim e The im porter could have drawn d ra ft on his United States bank, tance financing in recent years. promising to repay the bank in three months. Upon acceptance and receipt o f the funds (less the RECENT GROWTH PATTERNS discount), the im porter w ould rem it the funds to The outstanding amounts o f various types o f the exporter. In effect, the im porter w ould have dollar acceptances in the past decade are shown in delayed his final paym ent fo r three months, which Chart 1. It is apparent th a t acceptances to obtain would have provided tim e to sell the im ported dollar exchange and to finance the shipm ent or merchandise. Or the foreign exporter could have storage o f merchandise w ith in the United States used acceptance financing to buy merchandise (in no longer play a significant role in this sector o f this case, radios) p rio r to exporting. From the bank's standpoint, acceptances can be used to the money market. From 1960 through 1969, dollar exchange acceptances represented an aver accommodate a large credit demand: several drafts age o f only about 3 percent o f outstandings, while may be drawn and individually distributed among acceptances fo r domestic financing accounted fo r a group o f participating banks. a slightly A lm ost half o f the dollar acceptances created types o f acceptances became progressively less not im p o rta n t in the 1960's, particularly when mea United States exporters and im porters. sured in terms o f relative shares o f to ta l dollar are used to involve larger average share— 4 percent. Both finance transactions th a t do These acceptances fall in to tw o general groups: acceptances. Acceptances to O Federal Reserve R egulations A and B govern th e use o f acceptances as c o lla te ra l. Th e Federal Reserve System requires th a t o n ly endorsed acceptances be used as eligible finance th ird co u n try trade showed the largest grow th during the period under review. The outstanding volume o f these instru paper; banks endorse acceptances to pass legal title . ments rose from nearly $250 m illio n at yearend O acceptances represented tw o -fifth s o f acceptance 1959 to almost $2.3 b illio n at yearend 1969. Such O n ly a Tew m o d ific a tio n s are described here. F o r a m ore co m p le te discussion, see A c ce p ta n c e s ," Finance, 1969. Essays Federal T his in Reserve a rtic le also R o b e rt L. C ooper, "B a n k e rs ' D o m e s tic Bank and In te rn a tio n a l o f N ew Y o rk , A ugu st describes th e typ e s o f tra de financing in in 1960-1961, finan ced and discusses th e ro le o f acceptance dealers at length. 1969. T hird co u n try financing expanded very sharply (by more than 20 percent) 4 I b i d p. 67. 1963, and 1967. It m ight be ECONOMIC REVIEW C h a r t 1. BANKERS' ACCEPTANCES OUTSTANDING By Type of Transaction Financed B illio ns o f d o lla rs 6 ---------------------------------------------------------- G O O D S SHIPPED o r STORED in U. S G O O D S SHIPPED o r STORED in FOREIGN COUNTRIES U. S. EXPORTS END OF YEAR 1960 L ast e n try : 62 '64 '66 '68 70 Dec. '6 9 S o u rc e o f d a ta : F e d e ra l R eserve B an k o f N e w Y o rk presumed th a t the sharp gains coincided w ith an p a y m e n ts increase in w orld merchandise trade, but a compar borrowing by Japan, and short-term financing was ison o f indexes fo r both quantum and value o f used instead. Japanese traders used dollar accep trade, as published by the United Nations, shows tances to obtain funds at a cost th a t was lower no significant correlation w ith rates o f grow th in than the cost o f domestic sources o f funds. p ro g ra m con stra in e d long-term th ird co u n try acceptance financing. This suggests The volume o f acceptances to finance United that the relative availability o f other types o f trade States im ports and exports also increased sharply financing, the comparative costs o f financing, and from the preferences o f foreign 1959 to 1969, b ut not as rapidly as the borrowers have an volume o f th ird co u n try acceptances. Moreover, im portant influence on the use o f dollar accep the pattern o f increase in import-based accep tances. It is know n, fo r example, that the surge in tances was quite d iffe re n t fro m th a t fo r accep th ird co u n try acceptances in the past decade was tances used to finance United States exports. For due prim arily to Japanese borrowing to finance a example, export acceptance grow th was largely major increase in exports and im ports. D uring part confined to 1960-1961 and 1969. (Interestingly, of the volume this period, the United States balance o f of United States exports did not JU LY 1970 expand at an unusual rate in 1960-1961, again charges. In tu rn , the rate o f discount represents suggesting th a t the economic relationship between the current bid rate fo r acceptances o f sim ilar merchandise trade and the m a tu rity use o f acceptance financing is complex and determined by a number as traded in the secondary market. Because o f the com plicated financial relationships o f factors.) In contrast, the volum e o f dollar involved in acceptance financing, it is sometimes acceptances based im ports d iffic u lt to determ ine who bears the cost o f the showed fa irly steady grow th during the 1959-1969 financing; generally, the party arranging fo r the period (see Chart 1). In only tw o years, 1963 and credit pays. on United States S im ilarly, 1967, was the year-over-year increase less than 10 the relative cost of acceptance percent; both years coincided w ith a leveling in financing is com plicated. A United States bor merchandise rower, w ant to im ports to the United States. In fo r example, w ould compare versus alternative costs on bank loans (including the costs export acceptances bear o u t the conclusion th a t o f compensating balances, which are usually not general, the diverse patterns in im p o rt such financing is arranged more frequently by involved in acceptance financing), accounts receiv foreigners than able, and commercial paper. In recent years, rates by U nited States traders. This preference no doub t is due to the relatively lim ited on sources (and higher costs) o f financing available to slightly higher than m arket rates on d ollar accep the foreigners as compared w ith th e ir counterparts tances, b u t this margin w ould be more than offset in this coun try. by the additional fees and charges th a t accompany In the United States, fo r example, exporters and im porters can seek funds in the form o f comm ercial paper have, on average, been acceptances (see table). Moreover, relatively few borrowers can obtain funds in the commercial business loans from th e ir commercial banks, ex paper m arket.5 Sophisticated foreign borrowers p o rt governmental agencies, and seeking funds through d o llar acceptances might accounts receivable financing. Large traders can also be interested in comparing the cost o f a also borrow in the commercial paper and Euro Eurodollar loan o r a sterling acceptance w ith the dollar markets. Foreign exporters and im porters cost o f a d ollar acceptance. A t one tim e, the rarely have as many credit alternatives. Moreover, foreign borrow er m ight have "shopped a ro u n d " in the cost o f dollar acceptance financing tends to be the foreign exchange markets fo r funds denom i lower than the cost o f domestic credit in most nated in other major foreign currencies, b u t the credits from foreign countries. rise o f the E urodollar m arket— w ith its lower transactions costs, reduced exchange risks, and The costs o f borrow ing funds through dollar acceptances are determined by the freer movement o f funds— has probably curtailed accepting such borrowing. A major cost disadvantage o f a bank's fees and handling charges plus a rate o f foreign currency loan is the need to "hedge" the discount. Prime borrowers (a w ider group than loan to offset the risk o f a change in the value o f borrowers paying the prime business loan rate) pay the foreign currency. Hedging freq u e n tly increases a commission o f 1 1/2 percent, although cus the cost o f borrow ing a foreign currency. 5 tomers w ith lesser credit standings may be charged more and sometimes there are other fees and See "C o m m e rc ia l Paper, 1 9 6 0 -1 9 6 9 ," E c o n o m ic R eview , Federal Reserve B ank o f C leveland, M ay 1970. ECONOMiC REVIEW Comparative Costs of Banker: and Commercial Paper 1 9 5 9 -1 9 6 9 Acceptances Averages o f D a ily Rates in S econdary M arkets Average fo r Year A d ju s te d A cceptance C osts* Bankers' A cceptances C om m ercial Paper A d ju s te d Spread (basis po in ts) + 116 + 134 +125 + 131 +130 +134 +131 + 11 5 + 13 5 +128 5.01% 4.31 4.51 4 .8 6 5.27 5.72 3.519 2.81 3.01 3 .3 6 3.77 4.2 2 5.36 4 .7 5 5.75 7.61 3.85% 2.97 3.26 3.55 3.97 4.38 5.55 5.10 5.90 7.8 3 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 6.86 6 .2 5 7.25 9.11 * Includes a d d itio n o f 1 1 /2 percent fo r com m ission s and charges. Sources: Federal Reserve B u lle tin and Federal Reserve Bank o f Cleveland Secondary Market. Upon acceptance by a United States bank, a d ollar acceptance becomes a high-grade negotiable instrum ent th a t can be sold on other money m arket instrum ents because o f the higher costs o f handling acceptances. Posted interest rates tend to lag m arket devel in a secondary m arket if funds are needed before opments, the m a tu rity o f the b ill. The accepting bank can changes in supply and demand. rather than to respond q u ic k ly to Late in 1969, add the instrum ent to its own investment p o rt however, fo lio ; however, some banks trade in the m arket at announced th a t th e ir m arket quotes w ould be the prevailing rate. The secondary tw o dealers in bankers' acceptances m arket is subject to negotiation. The move was considered "m a d e " or maintained by a small group o f dealers necessary because o f increased trading a c tiv ity in in New Y o rk C ity th a t stand ready to trade fo r acceptances and more volatile interest rate move th e ir own accounts. Investors in bankers' accep ments in the money market. One dealer also cited tances also include United States corporations and the practice o f negotiating rates on some trans financial (including actions even w ith the existence o f posted rates, as central banks) and businesses, and the Federal well as the tendency fo r all dealers to have to institu tions, foreign banks Reserve System. H istorically, dealers operating in the m arket conform to a change in rates posted by any one dealer. In itia l m arket response to the new rate have posted rates on bankers' acceptances in the procedure was mixed. Some m arket observers secondary m arket at fixed levels. Both bid and believed th a t it w ould make it d iffic u lt fo r offered rates are posted fo r various maturities, commercial banks to determ ine the discount rates w ith the spread (from 1/8 to 1/4 percent) between on new d o lla r acceptances. A t present, five o u t o f the tw o quotes representing the dealer's p ro fit the seven major dealers continue to post rates margin. This margin is somewhat higher than those daily. J UL Y 1970 Investment Returns. secondary accepted by other banks (see Chart 2). From 1961 yields on bankers' acceptances closely follow ed through 1964, holdings o f acceptances o f other the banks pattern of In other general, interest rates in the showed v irtu a lly no net change, w hile 1960-1969 period. Yields on acceptances declined reporting banks' holdings o f th e ir own acceptances sharply rose by about $400 m illio n (or by 45 percent). in 1960-1961 and then rose gradually during the 1962-1965 period. In 1966, in response During to a general tightening in credit conditions, money increased only moderately. market rates rose sharply (b u t tem porarily) to the this period, bank reserve pressures In 1965-1966, however, member bank borrow highest levels since the early 1930's. Yields on ings rose sharply as money and credit conditions acceptances averaged 5.36 percent in 1966. A fte r moved tow ard restraint. A t the same tim e, bank declining b rie fly in 1967, interest rates clim bed to holdings o f d o llar acceptances declined. When record levels in 1968-1969. The average yield on credit conditions eased in 1967, banks again added prime bankers' acceptances (90-day m aturities) acceptances to th e ir po rtfo lio s, and by December reached 8.58 percent in December 1969. 1967, bank holdings reached $1.9 b illio n — a record level. Since then, the pattern o f bank investment in A t yearend 1969, $1.6 b illio n o f d o llar accep tances were held by accepting banks. The bulk (84 acceptances has changed significantly. Credit re straint became increasingly severe in 1969, as percent) o f the dollar volume represented bills reflected in the sharp clim b in bank borrowings retained by the accepting bank, w hile only 16 from th e Federal Reserve since November 1968. percent consisted o f bills originally accepted and From the end o f th a t m onth through the end o f subsequently sold by other United States banks. December 1969, however, bank holdings o f the Bank acceptances holdings changed noticeably during the period under review, apparently in response to change, o f other banks showed averaging somewhat more little than net $200 changes in bank reserve pressures. In 1959-1960, m illio n accepting banks retained less than $300 m illio n o f acceptances also declined less than might have their own been expected bills, w ith th e ir holdings increasing irregularly after August 1959. August 1959 also (see Chart 2). Holdings o f banks' own based on th e ir behavior during preceding periods o f reserve pressure. represented a peak in bank reserve pressures, as Some generalizations about bank investment in measured by member bank borrowings fro m the d ollar acceptances m ight be made on the basis of Federal Reserve System (see Chart 2). the 1959-1969 experience. First, bank a c tiv ity in When reserve 1959-1961 pressures diminished in the buying the acceptances o f other banks did not period (w hich included a period o f expand as fast as did the overall market. A t the dollar end o f 1969, bank holdings o f the acceptances o f acceptances rose sharply, reaching a peak o f nearly other banks were no larger than the average level $1.3 b illio n at the end o f 1961. (D uring this time, o f holdings in 1962. In the past, these bills were market yields on acceptances declined.) Holdings not necessarily bought to be held as investments, o f retained acceptances continued to rise more but rather to rapidly endorsement, to business recession), through bank 1964 p o rtfo lio s than holdings of of bills add a second bank's name, or the acceptance. Some foreign 9 ECONOMIC REVIEW C h a r t 2. B A N K H O L D I N G S of D OL LA R A C C E P T A N C E S Billions o f d o lla rs L a s t e n tr y : D e c. '6 9 S ources o f data-. B o a rd o f G o ve rn o rs o f the Fede ra l Reserve System a n d F e de ra l Reserve B an k o f N e w Y ork investors required such an endorsement. This development may reflect increased e ffo rt by banks practice declined in the past fo u r or five years, as to retain foreign trade customers or the judgm ent United that acceptances are preferred assets because o f States banks sold more o f th e ir own acceptances to their customers. th e ir short-term nature and attractive rates. In Second, there is a fa irly close inverse relation addition, credit restraint encourages banks to lend ship between bank holdings o f acceptances and through acceptance financing (rather than direct banks' reserve positions. As supplem entary evi loans) because the acceptances can then be shifted dence, in 1961-1964 and 1967, when member to other lenders, such as corporations and foreign bank borrowings were relatively low, to ta l bank investors. holdings accounted fo r about 45 percent o f all FEDERAL RESERVE OPERATIONS reported acceptances outstanding; in other recent As mentioned earlier, prime bankers' accep years, the banks' pro p o rtio n was below 35 per tances are considered eligible collateral fo r mem cent. Finally, suggests become that the less sensitive to 10 1968-1969 ber banks borrow ing fro m the Federal Reserve may have banks; they can also be used to secure Treasury credit restraint. This tax and loan accounts. In addition, the Federal experience acceptance in holdings JU L Y 1970 Reserve System is actively involved in the second seller w ill repurchase the instrum ents after a stated ary market fo r dollar acceptances. In the 1920's, period o f tim e at a predetermined yield. the System too, used acceptances as the principal Here, the d ollar volum e o f transactions is still In moderate, although it is much larger than the addition, the System bought and sold acceptances volume o f o u trig h t transactions. Repurchase agree fo r the accounts o f foreign correspondents, m ostly ments are made only w ith nonbank acceptance other central banks. A t th a t tim e, the m arket fo r dealers. instrum ent in its open m arket operations. acceptances (centered in London) was active and System transactions in acceptances are confined growing, reflecting a boom in w o rld trade after to bills endorsed either by the dealer involved or World War I. This boom was cu t short in the by a member bank oth e r than the acceptor. 1930's by w orldw ide depression, rising economic Because o f this, the Open M arket A ccount buys at nationalism, and repression o f trade in Europe. a discount o f 1/16 percent below the dealers' Foreign maintain selling rates fo r unendorsed acceptances. A lthough modest holdings o f dollar acceptances, but the central banks continued to the System usually purchases m aturities o f 90 days acceptance market did not really regain its im p o r or less fo r its own account, its foreign corres tance u n til after W orld War II, when international pondents w ill generally take bills w ith m aturities trade o u t to six months. In its operations as agent fo r recovered and the United States dollar became the w orld's vehicle currency. foreign On March 29, 1955, the System Open M arket A ccount was authorized to undertake operations System guarantees payment and charges an additional 1/8 percent. CONCLUDING COMMENTS fo r its own account in the bankers' acceptance m arket. (In this fu n ctio n , the Federal correspondents, the A lthough the outstanding volume o f bankers' Reserve acceptances has not grown as rapidly as th a t o f Bank o f New Y ork acts as agent fo r the entire other money m arket instruments, the acceptance Federal Reserve System to im plem ent actual trans has some unique advantages. It is well-suited to actions, just as it carries o u t open m arket oper finance international merchandise trade and prob ations ably contributed significantly in the 1 9 6 0 's to th e in U. S. Government securities.) Such operations in acceptances were used to encourage freer movement o f goods and capital thro u g h o u t the developm ent o f the acceptance as an im por the w orld. Its relative lack o f grow th can be ta n t instrum ent to finance international trade. The attrib u te d to the legal constraints associated w ith System's holdings are deliberately kept relatively docum entation and Federal Reserve use, as well as small. For example, in December 1969, o u trig h t to the fact th a t the underlying funds are specif holdings averaged less than $60 m illio n in compar ically tied to certain merchandise. In th a t sense, a ison w ith dollar acceptance is less speculative than, say, a outstanding a tota l o f nearly $5 1/2 b illio n in dollar acceptances. The Federal Eurodollar loan. Given a con tin u a tio n o f the Reserve Bank o f New Y o rk also buys bankers' recent grow th in w o rld trade and the need fo r acceptances under repurchase agreement to pro funds to finance trade, the fu tu re o f the bankers' vide tem porary reserves to the banking system acceptance looks favorable, g when needed. In these cases, the Federal Reserve buys acceptances w ith the agreement th a t the F o r a d e s c rip tio n o f repurchase agreem ents in general, see E c o n o m ic R eview , Federal Reserve B ank o f Cleveland, N ovem ber-D ecem ber 1969. » n ECONOMIC REVI EW A NOTE ON THE CURRENT DECLINE IN CORPORATE PROFITS The current decline in corporate earnings ranks significantly fo r extended periods o f tim e. 1 These among the longest and the largest o f the p ro fit periods generally coincided w ith economic reces declines in the post-World War II period. This sions and slowdowns in overall economic a ctivity decline reflects prim a rily the slowdown in overall (see Chart 1). The firs t tw o declines were associ economic a ctivity and some imbalances among ated w ith the 1957-1958 and 1960-1961 reces prices, costs, and p ro d u c tiv ity . sions and extended over fo u r and seven quarters, In view o f the length o f the tim e period and the magnitudes respectively. The th ird decline occurred during the involved, the current decline w ould seem to have economic slowdown in 1966-1967 and lasted only im portant im plications fo r capital spending plans, tw o quarters. The current decline in corporate corporate financing activities and, as a result, fo r p rofits began in the fo u rth quarter o f 1968 and the general course o f economic a ctivity in the continued through the firs t quarter o f 1970— the months ahead. This article compares the scope and latest quarter fo r which data are available. Thus, magnitude the o f the current decline in corporate earnings w ith those current decline in corporate p ro fits was o f the declines th a t have occurred since 1956. The article also considers ^Measures o f co rp o ra te p ro fits discussed in th is a rtic le some o f the apparent im plications o f the recent re fer to c o rp o ra te p ro fits , b e fo re taxes as re p o rte d in the behavior o f corporate profits, particularly fo r capital spending in the months ahead. n a tio nal incom e and p ro d u c t accounts. Data re p o rte d in these accounts are based on p ro fits as re p o rte d by the re cip ie n t fo r ta x purposes and m ay d iffe r in several respects fro m p ro fits as re p o rte d to shareholders. F o r a THE M A G N ITU D E OF THE DECLINE Since 1956, there have been fo u r periods in w hich corporate p ro fits (before taxes) declined fu r th e r discussion o f a lte rn a tiv e measures o f p ro fits , see E dm und A . M ennis, " D iffe r e n t Measures o f C orp ora te P ro fits ," F in a n c ia l A n a ly s ts J o u rn a l, S epte m be r-O cto ber 1962. U L Y 1970 C h a rt 1. C O R P O R A T E PRO A ll C o r p o r a t i o n s Billions of dollars 95 S E A S O N A L L Y A D J U S T E D A N N U A L R A T E -Q U A R T E R L Y ALL CORPORATIONS . ______ S c a le >N ■JANCIAL CORPO RATIONS - FINANCIAL CORPORATIONS S c a le 1956 Last entry: '58 '60 IQ 7 0 ^ B efo re taxes. Source of data: U. S. Department of Commerce exceeded in duration o nly by the decline associ decline ated w ith the 1960-1961 recession. between The current p ro fit decline also ranks among the largest in dollar terms, although it has been less severe in relative terms. A t the end o f the firs t in corporate the 1960-1961 p ro fits 1966-1967 ranks somewhere slowdown and the recession, w hich seems to be about where the current slowdown in overall economic o a ctivity w ould rank thus far. quarter o f 1970, the decline in corporate p ro fits amounted to $10.9 b illio n , compared w ith $11.3 b illio n during the THE SCOPE OF 1 HE DECLINE 1957-1958 recession, $10.2 As in previous periods of declining corporate billion during the 1960-1961 recession, and $5.4 profits, the current do w n tu rn has been centered in billion during the 1966-1967 slowdown. In relative the p ro fits o f nonfinancial corporations (see Chart terms, 2). corporate p ro fits have declined by 12 During the recent period, the p ro fits of percent through the end o f the firs t quarter of nonfinancial corporations declined by $12.0 b il 1970, compared w ith 23.7 percent during the lion. This decline was p a rtia lly offset by a $1.1 1957-1958 recession, and 18.5 percent during the 1960-1961 recession. During the 1966-1967 slow down in economic a c tiv ity , corporate p ro fits declined by 6.5 percent. Thus, the current relative 2 F or a discussion o f the scope and m a gnitud e o f th e c u r re nt slo w d o w n in overall e co n o m ic a c tiv ity , see " D im e n sions o f Recent E co n o m ic A c t iv it y , " E c o n o m ic C o m m e n ta ry , Federal Reserve B ank o f C leveland, June 8, 1970. ECONOMIC REVIEW C h a rt 2. CORPORATE PROFITS* Al! Nonfinancial Corporations Billions of dollars L ast entry: * IQ '7 0 B e fo re t a x e s. S o u r c e of data: U. S D epa rtm ent of C o m m e rce b illio n increase in the p ro fits o f financial co rp o r severe thus far than ations. 1957-1958 and 1960-1961. during the recessions o f W ithin m anufacturing, the durable goods indus T w o-thirds o f the current decline in the p ro fits tries experienced the largest decline in corporate o f nonfinancial corporations is the result o f lower p ro fits — at least through the fo u rth quarter o f earnings o f m anufacturing corporations. Profits in 1969 manufacturing pronounced have declined by 17.6 percent, (see Table in the I). The declines were most fo llo w in g industry groups: while there has been a 10.8 percent decline in the lumber and w ood products, 49 percent; m otor profits of transportation and u tilitie s companies vehicles and parts, 38 percent; and a ircra ft and and a decline o f 12.4 percent in the p ro fits o f all parts, 36 percent. However, prim ary iron and steel other and nonfinancial corporations. A lthough the current relative decline in m anufacturers' profits nonferrous metal products had steady in creases in p ro fits during this period. the It was impossible to com pute accurately the 1966-1967 slow dow n, it falls far short o f the decline in p ro fits th a t occurred in the nondurable declines during 1957-1958 and 1960-1961. On the goods industries during the recent period because other hand, the most recent decline in the p ro fits o f changes of other nonfinancial corporations has been more W ithin the nondurable goods category, however. exceeds the decline experienced during in certain industrial classifications. JU LY 1970 TABLEi Corporate Profits in Selected Industries During R and Slowdowns* Percent Change F ro m Peak to T roug h In d u s try 1 9 5 7 -1 9 5 8 1960-1961 -4 9 % -5 2 -6 1 -5 3 -7 5 -6 2 -4 6 -5 0 -3 0 -9 7 -3 8 -2 8 -4 4 -4 4 % - -8 6 -4 0 -4 9 -6 9 -4 2 -7 8 -3 2 -3 7 -3 6 -3 2 -5 5 -6 5 -2 9 - 9 -1 2 8 -2 0 D urable goods L u m b e r and w o o d p ro d u c ts F u rn itu re and fix tu re s S tone , cla y , and glass P rim a ry iro n and steel N o n fe rro u s metals Fa bricated m etal p ro d u cts M a ch in e ry, exce pt electrica l E le ctrica l m a chinery M o to r vehicles and parts A ir c ra ft and parts Instrum e nts Miscellaneous and ordnance 1966-1 967 18 % - -3 9 -4 4 -4 0 -1 8 -1 1 -1 1 -5 1 -1 5 - 6 - 7 - 7 4 - 2 N o n d u ra b le goods Food p ro d u c ts T o bacco m a nufa cture s T e x tile m ill p ro d u c ts A ppa rel and p ro d u c ts Paper and p ro d u c ts P rin tin g and p u b lis h in g Basic chem icals Drugs P e tro le u m and p ro d u c ts R ubb er and m iscellaneous plastics Leather and p ro d u c ts — 30 — 7 — 17 — 59 — 47 — 19 — 38 — 42 -1 5 — 47 n.a. — 39 — 9 — 3 — 1 — 48 — 49 — 16 — 30 — 23 -1 3 — 5 — 29 — 59 -2 1 -1 1 A ll m a n u fa c tu rin g — 41 — 28 -1 2 19 68-1 969 11 % t t - 7 - 5 -1 9 -3 8 -3 6 - 5 - 9 n.a. t t - 9 -2 9 -3 7 -2 4 -1 0 n.a. -1 5 - 7 -2 7 - 5 t -2 9 -2 4 - 8 -2 3 -1 8 * B efore taxes. t D enotes increases d u rin g th e pe riod. Sources: Federal Trade C om m ission and S ecurities and E xchange C om m ission. Seasonally ad ju sted by Data Resources, Inc. R e p rin te d w ith the perm ission o f The F irst N ation al C ity B ank o f New Y o rk . large declines occurred in apparel (29 percent) and contrast, during the 1966-1967 period, earnings in rubber and miscellaneous plastics (23 percent). declines o f 30 percent or more on this basis were Profits increased in the food products and tobacco reported manufacturing industries during the recent period. 1960-1961, and 16 in 1957-1958. A lthough seasonally adjusted data by six industries, 13 industries in are not available fo r the firs t quarter of 1970, as o f the The recent decline in corporate p ro fits reflects, end o f the fo u rth quarter o f 1969, three out o f 26 in part, the general slowdown o f economic activ durable and nondurable goods industries reported ity. Beyond this, however, there are some fu n d a pre-tax p ro fit declines o f more than 30 percent. In mental imbalances th a t have been eroding p ro fit ECONOMIC REVIEW C h a rt 3. S E L E C T E D D E T E R M I N A N T S of P R O F I T M A R G I N S INDEX 1957-59=100 L ast entry: * IQ Percent '7 0 Not s e a s o n a lly adjusted. So u r c e of data: U. S. D e p a rtm e n t of C o m m e rce margins since 1966 (see Chart 3). P ro fit margins in percent during this period. These increases were m anufacturing have fallen 1.7 percentage points, partially offset by an increase o f approxim ately 12 or by 1.7 cents per dollar o f sales, fro m the firs t percent in prices. Thus, p ro fit margins generally quarter o f 1966 through the firs t quarter o f 1970. absorbed the difference between rising prices and This decline is largely the result o f rapid increases more rapidly rising costs. in labor compensation th a t were combined w ith The data on p ro fit margins shown in Chart 3 on ly moderate rates o f growth in p ro d u ctivity. are, however, averages th a t apply only to manufac Between the firs t quarter o f 1966 and the firs t turing corporations and are based only on sales. quarter o f 1970, labor compensation in manufac Even on this basis, the spread o f p ro fit margins turing rose by more than 30 percent, w hile o u tp u t ranged per manhour increased by only about 11 percent. percent. As a result, u n it labor costs rose by more than 18 margins on sales in from nearly 10 percent to a mere 1 In nonm anufacturing industries, p ro fit 1969 were as high as 17 percent during this period. In addition to increased percent. Furtherm ore, more than three-fourths of un it labor costs, net interest costs in m anufactur all reporting m anufacturing industries had a rate o f ing more than quadrupled, capital consum ption return on net w o rth o f more than 10 percent in allowance rose by more than 25 percent, and 1969. Nevertheless, the conclusion still holds that indirect business taxes increased by almost 10 p ro fit margins in m anufacturing, on average and in JU L Y 1970 C h a r t 4. SOURCES and USES of FUNDS: Nonfinancia! Corporations Billions of dollars 0 Billions of dollars INTERNALLY GENERATED — SOURCES of FUNDS' RAISED in CREDIT MARKETS i 3 0 MOVING AV ER AG E-SEASO N ALLY ADJUSTED ANNUAL RATE Percent L ast e n try : 3 Q '69 S o u rc e o f d a t a : B o a rd o f G o v e rn o rs o f th e F e d e ra l R e serve S yste m terms o f sales, have been "squeezed" between late 1968 firm s have been forced to rely more rapidly rising costs o f all types and less rapid heavily on external sources o f funds to finance increases in prices and pro d u ctivity. capital spending. IMPLICATIONS spending plans conducted by the U. S. Departm ent A ccording to the most recent survey o f capital The recent decline in corporate p ro fits seems to o f Commerce and the Securities and Exchange have some im plications fo r fu tu re capital outlays Commission, business firm s plan to spend a p p ro xi and financing these outlays. mately 8 percent more on plant and equipm ent in During 1967 and the early part o f 1968, firm s 1970 than in 1969.3 If realized, this am ount o f relied mainly on internal sources o f funds (re spending would tained earnings and depreciation allowances) to c u rre n tly anticipated rate o f grow th o f internal finance the surge in plant and equipm ent expendi sources o f funds. Thus, firm s w ill have to continue tures that follow ed the slowdown in economic to rely heavily on external sources o f funds to the methods of seem to be in excess o f the a ctivity in 1966-1967 (see Chart 4). By the fo u rth quarter o f 1968, however, internal sources of n h e results o f the m o st recent survey appear in th e June funds began to decline, reflecting the general downward trend in corporate profits. Thus, since 1970 issue o f the S urve y o f C u rre n t Business, U. S. D e p a rtm e n t o f C om m erce. 17 ECONOMIC REVIEW TA B LE II Percent Changes in Corporate Profits and Revisions Of Capita! Spending Plans Revisions in Planned C apital E xp e n d itu re s C orp o ra te P ro fits 19 68 -1 9 6 9 11IQ 68 - IQ 70 A ll Ind ustries T ra n s p o rta tio n , c o m m u n ic a tio n s , and p u b lic u tilitie s Sources: U. S. D e p a rtm e n t C om m ission -3 .3 % - -1 7 .6 -2 8 .2 - 3.4 -4 .7 -0 .4 -1 .5 - 10.8 -3 .0 - M a n u fa c tu rin g D ura ble goods N o n d u ra b le goods of - C om m erce and 1 9 6 9 -1 9 7 0 12 . 0 % S ecurities and 2 .8 % 6.1 -7 .3 -4 .8 -0 .3 Exchange finance capital outlays during 1970, particularly in have declined by only 3.4 percent, and spending the second and th ird quarters, when expenditures plans have been reduced less than in durable goods are expected to rise by approxim ately 3 percent in industries. each quarter. There is some lim ited evidence, however, th a t CONCLUDING COMMENTS suggests that actual capital spending may fall short The current decline in corporate p ro fits has o f current expectations. During 1969, businessmen been centered in nonfinancial corporations, p ri reduced their planned am ount o f expenditures by m arily more than 3 percent (see Table II). In the most through the firs t quarter o f 1970 was not as large recent survey (conducted in late A p ril and May), as the declines associated w ith the 1957-1958 and in m anufacturing. A lthough the decline firm s reported that they had reduced th e ir planned 1960-1961 recessions, it nevertheless has im p o r spending fo r 1970 by nearly 3 percent from what tant im plications. they had o riginally reported in the survey con ducted in the fall o f 1969. The largest reductions The most obvious effects o f the current decline appear to have occurred in those industries th a t in p ro fits and internal cash flo w w ould seem to be experienced the largest declines in corporate p ro f on capital spending plans and external financing its. For example, p ro fits in the durable goods requirements. Further increases in capital spending industries declined nearly 30 percent between the w ill apparently have to be financed largely by th ird quarter o f 1968 and the firs t quarter of external sources o f funds. Thus, the am ount o f 1970, and firm s in those industries trim m ed their spending th a t takes place in the months ahead w ill spending plans fo r 1970 by more than 7 percent. depend to a considerable extent on the availability Conversely, p rofits in nondurable goods industries and the cost o f credit.
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