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UPDATE 3-China's Chaori Solar poised for landmark bond default

* Chaori says can't make 89 mln yuan interest payment due Fri

* Would be first-ever default in China's domestic bond market

* Default positive for rational risk pricing in China - analysts

* Chaori default unlikely to spark panic-driven chain reaction

* Government seen likely to allow more defaults

(Adds market reaction, context, analyst quotes)

SHANGHAI/HONG KONG, March 5 (Reuters) - Loss-making Chinese solar equipment producer Chaori Solar said it will not be able to meet interest payments on bonds due on Friday in what would be the country's first-ever domestic bond default, and possibly the first of many.

The warning by Shanghai Chaori Solar Energy Science and Technology Co Ltd highlights rising credit risk in China, where a massive run-up in corporate debt since 2008 - and overcapacity in sectors such as steel, coal and solar - have threatened the solvency of many borrowers.

A precedent-setting default, however, could benefit the economy in the long run by heralding the end of an era of risk-free credit in China, where local governments have often used public funds to rescue weak firms in order to prevent financial and social instability.

"2014 will be the year China seriously cleans up mounting local government and corporate debts," Lu Ting, China economist for Bank of America-Merrill Lynch in Hong Kong, wrote in a note.

"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," he added.

In a stock market filing late on Tuesday, Chaori Solar said it could only pay out less than five percent of the 89 million yuan ($14.5 million) in interest due on 1 billion yuan worth of bonds issued in 2012.

"As such, the company will not be able to fully pay the interest on the 'Chaori-11 bond' in time on March 7," the company said.

Investors took the news in their stride. The cost of buying protection against a default by the Chinese government within the next five years, which typically rises if markets are fearful about credit risk, actually fell by 6 basis points in morning trade.

The benchmark yield on five-year corporate bonds rated AA- <AA-M5Y=CFXS> was flat at 7.27 percent, well below the record high of 8.07 percent set on Dec. 30. AA- is the lowest rating at which most companies are able to sell paper in China's domestic market.

"We judge the systemic risk to the overall bond and financial markets from this potential default to be small," Barclays analysts wrote in a note to clients.

"The likelihood of a credit or a financial crisis, and its overall macro and growth impact, is also small for now."

China's domestic bond market was worth 9.3 trillion yuan ($1.5 trillion) at the end of last year. The overall bond market is the world's third largest after the United States and Japan.

NO WHITE KNIGHT

Chaori narrowly avoided a bond default in January 2013 after a local government in Shanghai persuaded banks to defer claims for overdue loans, which enabled the company to meet interest payments.

This time, however, a last-minute rescue appears unlikely.

The Shenzhen stock exchange, where Chaori's bond trades, requires issuers to notify investors two days in advance of scheduled payments and Chaori's notice late on Tuesday indicates it is already resigned to missing the deadline.

But the company also said it was working to secure the necessary funds, leaving open the possibility the interest payment may occur after a delay. The bond matures in March 2017 and carries an interest rate of 8.98 percent.

Analysts say a default could help reduce the moral hazard caused by the widespread assumption that corporate bonds, regardless of the financial health of the issuer, enjoy an implicit guarantee from the government and state banks.

"Onshore investors are now likely to sell higher risk bonds and in the short term there will be a flight to quality," said Moody's Hong Kong-based senior credit officer Ivan Chung.

"In the longer term it will change investor expectation of a default. They will factor in more credit risk for pricing in expected yields for bonds."

Chaori's default warning also coincides with the annual meeting of China's political leadership, which could be a sign of the government's commitment to clamp down on borrowing by weak companies and wasteful investments, ratings agency Fitch said in a note. China is trying to reduce its reliance on investment for economic growth.

OFFSHORE DEFAULTS

While domestic bond defaults are so far unprecedented, Chinese markets were on edge last month when a high-yield investment product issued by China Credit Trust Co Ltd warned it may not pay out on maturity.

That product eventually paid out principal, though not interest, after an unnamed white knight stepped in, but a few days later, another high-yield product issued by Jilin Province Trust failed to pay out on schedule.

Both trust products were based on loans to deeply indebted coal companies.

Defaults on offshore bonds issued by Chinese firms have occurred before. LDK Solar Co Ltd's missed several interest payments on offshore U.S. dollar bonds last year.

China's solar industry has in recent years suffered from severe overcapacity and falling prices for photovoltaic cells, while the government has been embroiled in a trade war with the United States and the European Union

Chaori on Friday reported a net loss of 1.33 billion yuan for 2013, less than its loss of 1.68 billion yuan in 2012. But the operating income fell by 60 percent in 2013, in a sign of its ongoing struggles. ($1 = 6.15 Chinese yuan)

(Additional reporting by Kazunori Takada in SHANGHAI; Editing by Miral Fahmy)