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What that China debt default means to the market

China has experienced its first corporate debt default in at least 17 years, and that might be the best thing that's ever happened to its bond market.

The country's path to meaningful financial reform depends on its ability to have a legitimate, open system, and a long tradition of refusing to allow weak companies to fail at any level has undermined that goal.

Web page of Chaori Solar Energy
Source: Chaori Solar Energy
Web page of Chaori Solar Energy

Now comes news this week that Shanghai Chaori Solar Energy Science & Technology was unable to make an 89 million yuan ($14.5 million) interest payment Friday.

In most free market countries, such a small payment from a relatively tiny company would barely cause a ripple. But in a land where commerce is so strictly controlled by a government that has professed a strong desire to implement more legitimate business dealings, this is a huge deal.

"It is a wake-up call for market participants," Ivan Chung, senior credit officer at Moody's Investor Service, said in an email interview with CNBC.com. "It will galvanize investors and regulators to pursue reforms in investor protection infrastructure (e.g., introduction of covenants), better disclosures and governance."

(Read more: China allows first corp bond default)

That's the good news.

The bad news is if you're a company teetering on the brink of a similar default, it would be wise not to expect the government or a big bank to come rushing to your rescue.

"The previous bailouts in the Chinese onshore bond market created moral hazards and encouraged investors to seek the highest yields while overlooking the credit risks," Chung said. "The default will galvanize investors and regulators to pursue the needed reforms."

Analysts expect the Shanghai Chaori default to be a test case that, absent any major contagion, will lead to higher borrowing costs and still more defaults.

(Read more: We see 'less and less cash' in system: Soho China CEO)

Standard & Poor's analysts in Hong Kong called the default a "transformative event" for China's bond market that nevertheless probably won't pose systemic credit risks.

"We believe this landmark event will make lenders and investors more disciplined, and it will likely lead to higher funding costs and tighter refinancing conditions for low-quality corporates," S&P credit analyst Christopher Lee said in a statement.

The firm said it believes China's government "is beginning to address the difficult moral hazard and implicit state guarantee of financially weak and commercially unviable borrowers."

China's nearly $14 trillion corporate debt market is a minefield often filled with overpriced securities for companies that reap the benefits of having implicit government guarantees.

(Read more: Why China needs a national property tax)

From an investor standpoint, though, changing the stance toward bailouts offers the opportunity of a more stable system in the long term as China seeks to gain greater acceptance in the global community.

"We see onshore corporate credit defaults as a long-term positive for China's financial system as it should instill greater market discipline and lead to a more efficient allocation of capital among corporate borrowers," the Fitch ratings agency said in a statement. "It may also prompt further regulatory progress to provide more clarity on the legal process governing domestic bankruptcies and restructuring, which should benefit both onshore and offshore creditors in the long run."

More precisely, the reforms could invite other investors into the market who would be scared off otherwise.

"They want to free up interest rates. They want to let new players into the market," Richard Martin, managing director of IMA Asia, told CNBC.

"This means market pricing of capital, and a default on a badly managed bond is part of that. I think they can let this one go and we might see one or two a month as we go from here, and then we'll see better pricing of the bonds."

—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.

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