OREANDA-NEWS. A greater possibility of default in China would inject greater credit discipline and foster more efficient allocation of capital, Fitch Ratings says. However, allowing widespread defaults without transparent criteria for selecting debtors who would be allowed to fail, and without a robust, predictable framework for supporting lenders absorbing credit losses, would risk provoking a "credit crunch" with significant destabilising effects on the economy and banking sector.

Defaults by Chinese state-owned enterprises (SOE) in particular have accelerated following the first onshore SOE corporate bond default on principal by Baoding Tianwei in February. Thus far in April, two other SOEs have missed bond payments while a third has had trading of its notes suspended. These were on top of a number of other onshore corporate bond defaults by private-sector firms so far this year. However, the overall default rate remains negligible compared with that in developed markets. Fitch does not expect China's explicit bond default rate to rise anywhere near levels in developed markets.

Allowing market forces to play a greater role in the debt market should, over the long run, reduce moral hazard and contribute toward sustainability and predictability for investors. However, a rise in default rates closer to those in some developed markets would carry risks to financial stability unless the process can be managed under a transparent and consistent framework. The risk is lenders would be left uncertain as to which SOEs will be allowed to default and over the process for resolving creditors' claims.

The Chinese authorities still exert significant influence over the financial system, but this control is less than it was a decade ago given the development and growth of the shadow banking system. Therefore, an unexpected credit event and resulting risk aversion emanating from the shadow banking system now has a greater chance of triggering broader financial instability. In this scenario, even government controlled banks could become risk averse and be unwilling or unable to lend - a feature evident in other government-controlled banking systems in emerging markets.

A significant tightening in credit conditions could lead to a hard landing, under present macroeconomic conditions in China. The system is already under strain from a broader context of decelerating growth, weakening bank asset quality and significant leverage growth over the past decade. More robust institutional machinery for resolving defaults may be needed to avoid too great an intensification of risks to financial stability.

China's onshore bond issuance has surged over the past year, doubling yoy to CNY1.24trn (USD192bn) over the first two months of 2016. That said, the recent defaults from both the private sector and SOEs could have contributed to a spate of cancellations of bond issues in March and April.

Risks could stem from corporate sectors that are experiencing severe over-capacity and weakened credit profiles, but have also benefited from implicit government support in the past. If investors rapidly change their perceptions of government support in these sectors, it could lead to a disorderly deleveraging.