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By Min Zeng, DJ FX Trader

In another sign of growing nervousness about the euro zone’s debt troubles, the amount of outstanding U.S. commercial paper sold by foreign banks has dropped $58 billion in the past two months.

The shrinkage suggests that foreign banks have been allowing maturing commercial paper to roll off, without issuing more of this short-term debt, amid weak demand from U.S. money funds and other investors. Many money fund managers have become more selective in buying such short-term bank debt as worries about the euro-zone’s public finances have caused a significant outflow of their assets over the past few weeks.

The amount outstanding of dollar-denominated commercial paper issued in the U.S. by foreign banks fell by $16 billion to $301 billion in the latest week ended Wednesday, according to data released Thursday by the Federal Reserve. The amount has fallen from the recent peak of $359 billion for the week ended May 11.

So far, there is little sign that U.S. money funds are selling commercial paper in droves. Rather, they are tending to invest in shorter-dated instruments in an effort to reduce risk.

Another cushion for euro-zone banks comes from ample liquidity from central banks. The Federal Reserve on June 29 extended its dollar swap line with the European Central Bank so that euro-zone banks can tap this for dollar funding needs.

But some market participants said the shrinkage signaled growing nervousness among investors. Should the euro-zone debt problems worsen, U.S. money funds could pull back significantly from the commercial paper market, which could pull the plug on a major funding source for euro-zone banks. This market’s paralysis was one of the key catalysts for the global financial crisis in 2008.

“If outflows from prime money funds continue, it may ultimately result in higher short-term borrowing costs for banks,” said Brian Smedley, interest rate strategist at Bank of America Merrill Lynch who specializes in short-term funding markets.

Over the past month, about $90 billion flowed out of prime institutional money funds, a key buyer of commercial paper, according to data provider iMoneyNet.

“We haven’t stopped investing in euro-zone banks, but we are watching the situation closely and I am feeling more comfortable holding maturities of three months or less,” said Jeff Given, portfolio manager with Manulife Asset Management in Boston, who oversees $17 billion in fixed income assets including money market funds.


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