Silver spot price rises after ‘orderly’ Chinese investment default

Shanghai (Jan 29)  The spot price of silver has rebounded today from its recent lows after the ‘orderly’ default of a troubled Chinese wealth-management product (WMP) reduced the risk of a credit crunch in the world’s second-largest economy. The People’s Republic of China plays a central role in commodity markets and has accounted for much of the increase in global demand over the past decade.

China Credit Trust today announced that it has resolved the restructuring of an investment trust product called ‘Credit Equals Gold #1’ (CEG1). The WMP was used to finance a loan to a now-failed coal-mining company and was due to expire on 31 January, at which point the PRC would have had to deal with the first default of a popular form of investment product.

According to at least some observers, the fate of China’s $5 trillion shadow banking system had been hanging on the resolution of the troubled $469-million investment product, with fears that a default on CEG1 would undermine confidence in WMPs generally.

Now however, an asset management firm has stepped up to purchase the fund from China Credit Trust and, presumably, take control of the bankrupt mining company whose equity had been used as collateral in the trust product. In the result, financiers of the product will get back their principal but not the promised interest payment of more than 10 percent. There is thus a haircut for the investors and technically a default, even if the loss is relatively modest.

Danske Bank senior analyst Flemming Jegbjærg Nielsen writes that “the orderly default of CEG1 probably means that the risk of a major negative credit event later this week has been avoided”. Nielsen thinks though that there is “a high likelihood” that analogous cases could arise in the coming months because similar loans made in China “could be regarded as sub-prime or junk debt”.

He says that it’s at least arguable that “a more severe default on CEG1 could have been healthy for the long-term development of China’s financial sector”, inasmuch as it would have sent a clear message to investors of the real underlying risks in such investment products. “In that sense,” argues the Danske analyst, “the partial bail-out announced today has just kicked the can ahead.”

That’s a view shared by Bank of America Merrill Lynch economist David Cui, who describes China’s shadow banking system as “one of the biggest moral hazards in the financial market globally in recent years”.

In a research note published yesterday, Cui wrote that if customers are reassured that their investments are guaranteed, Chinese shadow credit will continue to grow exponentially for now. The alternative was likely to be much more painful in the short term, but letting investors swallow the losses would have forced Chinese WMP buyers to acknowledge the underlying risks.

Responses to an online survey conducted by Sina Finance showed that more than 70 percent of Chinese people would not invest in trust products if WMPs were to be no longer guaranteed.

The finding suggests that regulators need to address the moral hazard problem soon, at which point “things may get ugly rather quickly,” opines Cui. “After all, the stability of the shadow banking sector is based on public confidence and we all learned from the subprime crisis that confidence is a fickle thing when the ground below is crumbling.”

Right now, spot silver is trading at around $19.768, up 0.21 percent intraday or exactly twenty cents above its 18-day low set yesterday