* Market focused on recent shadow bank bailout
* But moral hazard in bond market is even more harmful
* Lack of defaults distorts capital allocation
* Weak borrowers get cheap funds as investors ignore risk
SHANGHAI, Feb 11 (Reuters) - Keeping China's debt bubble from bursting and dragging the economy down with it may require painful medicine that the country's leaders have so far been unwilling to swallow: letting some borrowers go bust.
Widespread bankruptcies are just what China wants to avoid, yet the near total absence of defaults is preventing China from putting a lid on runaway credit and wasteful investment, economists and analysts say.
Market watchers were transfixed last month by the saga of "Credit Equals Gold #1," a high-yielding trust product backed by a loan to a troubled coal mining firm, which looked poised to set a precedent for defaults in China's shadow banking system.
But just as in previous cases, an unnamed white knight -- most likely the local government -- stepped in at the last moment to ensure that investors recovered their principal.
The apparent bailout revived concerns about moral hazard. By reinforcing the perception that even high-yield investments carry an implicit guarantee from the government and state banks, such rescues encourage reckless lending, economists argued.
Yet the problem of moral hazard and inefficient credit allocation is arguably even more serious in China's bond market than in the trust sector. That's because policymakers are counting on the 9.3 trillion yuan ($1.53 trillion) corporate bond market to play a key role in improving capital allocation in China's financial system.
Because bonds trade regularly, unlike bank and trust loans, bond prices provide the most up-to-date signals on how investors judge the default risk posed by various types of borrowers. In mature economies, bond yields are the benchmark against which loans and other forms of credit are priced.
Credit markets that treat default as a realistic possibility would likely channel less funding to coal mines, steel factories, and other industries plagued by overcapacity and populated by loss-making firms.
That would help to wean China's economy off its reliance on debt-fueled investment and aid its rebalancing towards consumption and services.
But in a market that views bailouts as the norm, investors dole out funds based on their perceptions about strength of a borrower's relationship to the government, rather than the quality of its underlying business.
"So far, there has yet to be a (bond) default. That means genuine credit risk is lacking," said Zhang Zhiming, head of China research for HSBC in Hong Kong.
"This needs to be sorted out before corporate bonds truly become a more efficient way of allocating resources. If genuine credit risk isn't there, it means price efficiency is questionable."
LOW, LOW PRICES
Mis-pricing in the bond market can be seen in the low interest rates that even apparently risky borrowers pay for cash.
China Railway Construction Corp Ltd. sold 10 billion yuan worth of seven-year bonds in June at only 5.10 percent, below the central bank's lending rate benchmark of 6.55 percent for long-term loans and just 147 basis points (bps) above the yield on benchmark seven-year government bonds at that time.
Yet in a market where defaults were viewed as a genuine possibility, a heavy debt load would likely force borrowers to pay higher rates to compensate investors for the risk.
China Railway's ratio of liabilities to assets stood at 85 percent at the end of March, the latest reporting period before it issued its bonds.
China's top economic planning agency, the National Development and Reform Commission (NDRC), said last year that firms with ratios above 80 percent must obtain third-party guarantees in order to win approval to issue bonds, while a ratio above 90 percent would trigger an automatic denial.
But medium-term notes are overseen by the central bank and aren't subject to approval by the NDRC.
Despite the lack of defaults, some market watchers say the market is showing some early signs of increased sensitivity to credit risk. Several new bond issuers have been forced to pay hefty interest rates to raise funds.
A city government financing vehicle in the populous but poor inland province of Hubei, Huangshi Cihu High-Tech Development Co Ltd, sold seven-year bonds in late January with a 9.30 percent coupon, a fat spread of 484 bps above government bonds.
Another financing vehicle in the rust-belt northeast province of Liaoning, Jinzhou Economic and Tech Development Group Co, sold seven-year bonds at 9.10 percent on the same day. Both firms were rated AA-.
Overall, the spread between lower-rated corporate bonds and government bonds has widened in recent weeks. (GRAPHIC: China corporate bond spreads http://link.reuters.com/zyr95t)
Still, market players are sceptical that 2014 will witness China's long-awaited first-ever bond default. Most expect the government will allow a trust default first as an incremental step, since the number of people affected would be smaller.
"The government is still too afraid of instability to allow real (bond) default. I don't see it happening this year," said a bond fund manager at a Sino-foreign joint-venture fund management company. ($1 = 6.0593 Chinese yuan)
(Additional reporting by Shanghai Newsroom; Editing by Kim Coghill)