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Rare bond default warning in China a good thing?

A rare bond default warning from a Chinese firm unsettled markets in Shanghai on Wednesday, but should be seen as a positive sign of reform taking place in the world's second biggest economy, analysts say.

In a statement posted on the Shenzen stock exchange's website late Tuesday, Shanghai Chaori Solar Energy Science and Technology said it will be unable to meet interest payments on bonds due this Friday.

It was scheduled to deposit 89 million yuan ($14.5 million) in interest on Wednesday for the 1 billion yuan "Chaori-11 bond" it issued in 2011, but was only able to pay 4 million yuan, Reuters reported. This means the firm will not be able to fully pay the interest for the 'Chaori-11 Bond" in time on March 7, the firm said.

Tourists view the Pudong financial district skyline from the historic Bund in Shanghai.
Mark Ralston | AFP | Getty Images
Tourists view the Pudong financial district skyline from the historic Bund in Shanghai.

The news weighed on Chinese stocks, with the benchmark Shanghai Composite stock index down 0.2 percent in mid-day Asian trade – bucking a generally firmer tone in Asian equity markets.

(Read more: China liquidity situation is 'troubling': Soho China)

Last year, Chaori avoided a bond default after a local government persuaded banks to defer claims for overdue loans and this allowed the firm to meet its bond interest payments.

While the sums involved are small, the significance of the default should not be over looked, analysts said.

According to analysts at Bank of America Merrill Lynch (BoAML), this will be the first default of an onshore bond in China.

(Read more: China sets 2014 growth target at 7.5%)

"China needs to become a more open market and allowing this default could be a psychologically important step in this direction," said Chris Weston, chief market strategist at trading firm IG in Melbourne.

"People need to realize that if you invest in a triple-C rated junk bond there is a risk and up until now there just hasn't been that perception," he added.

BoAML analysts also outlined why their initial reaction to the Shanghai Chaori news was positive.

"We think it's a good thing as a normal economy needs defaults to better price bonds and other debt products," they said in a note. "There's no need to worry. Let's not underestimate Chinese onshore investors' resilience. Defaults of some debt products are not on a similar scale to a collapse of a major financial institution."

They said that the bond default could be seen as good news for less risky debt products but negative for riskier debt products, adding that China needed to improve its bankruptcy laws and legal procedures to promote healthily growth of the corporate bond market.

(Read more: China minting billionaires at 'phenomenal' rate: Forbes)

The news from Shanghai Chaori came ahead of a slew of headlines from the first day of the annual meeting of China's parliament, the National People's Congress.

China set its gross domestic product (GDP) growth target for 2014 at 7.5 percent, as expected.

"2014 will be the year China seriously cleans up mounting local government and corporate debts which have been rapidly accumulated since late 2008," the BoAML analysts said.

"We believe the chance of some bond and trust loan defaults will rise significantly in 2014, especially as the more confident government sees the need for some defaults to develop a more disciplined financial market," they added.

— By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter @DharaCNBC

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