Dongbei Special Steel workers examine steel pipes at a plant in Dalian, northeast China's Liaoning Province, on February 18 (XINHUA)

The Dongbei Special Steel Group Co. Ltd., which has repeatedly defaulted on several bonds in 2016, reneged on yet another bond obligation in July. All parties involved are speculating as to whether or not the steelmaker is capable of reaching an agreement with its bondholders.

As painful as it may be, a market-based approach should be adopted to solve the default crisis. More specifically, presumptions that the government will help pay off its debt should be abandoned. A healthy market environment is crucial to preventing debt risks of state-owned enterprises (SOEs) from destabilizing the entire financial system.

Since its first default on March 28, Dongbei Special Steel has missed payments on seven corporate bonds valued at 4.77 billion yuan ($717 million). The company and its majority shareholders have yet to work out a debt repayment plan that satisfies its creditors. The company, a majority of which is owned by the Liaoning Provincial Government, is one of the three largest specialized steelmakers in the country.

The steelmaker is not an isolated case in China's ailing bond market. According to financial information provider Wind Info, a total of 16 Chinese companies have defaulted on corporate bonds worth a total of 40 billion yuan ($6 billion). In 2016 alone, 10 companies missed payments on bonds worth 16.9 billion yuan ($2.54 billion). A sustained increase in the number of credit defaults this year has sounded the alarm on the growing danger present in the bond market, alerting investors to the lurking risks.

In China, conventional wisdom holds that while the government may allow insignificant private firms to default, they will not allow SOEs to miss debt obligations given the impact they have on the economy. Against this backdrop, investors assume that SOE-issued bonds are implicitly backed by the state and that the government will help pay back the debt in case of a default.

As such expectations persist in the bond market, companies with high credit ratings may end up having bond yields similar to those of high-risk firms. The credit ratings of a large proportion of companies, especially locally administrated SOEs, have been overvalued for a long time.

This has two main consequences. First, high-risk firms don't have to pay high prices to raise funds in the bond market. Since the market's role in allocating resources hasn't been made the most of, this results in a waste of financial resources. Second, those high-risk bond issuers are mostly from sectors burdened by overcapacity, such as the steel and coal industries. Therefore, some of them have managed to survive despite the fact that they would normally have gone out of business. This is another obstacle to China's ongoing supply-side structural reform.

The financial market is one where risks are priced. The promise of government bailouts has deprived market participants of a clear understanding of credit risks, and as a result, these risks can't be properly assessed or priced through bond yields. Worse yet, government credit has been abused, and large numbers of bond issuers with artificially inflated credit ratings are still raising funds, posing a threat to the entire bond market. If the government doesn't desist in its policy of coddling the bond market, risks are likely to accumulate and could possibly spread to the entire financial market.

Local governments' administrative interventions and implicit guarantees, together with expectations for government bailouts, are the reasons why locally administrated SOEs like Dongbei Special Steel can issue so many bonds despite excess capacity and a broader economic slowdown.

Such measures have distorted the bond market and continue to cause the market mechanism to malfunction, sowing the seeds for continuous debt defaults. A large sum of bonds worth about 4.45 trillion yuan ($669 billion) will mature in 2016, and more defaults are likely to occur later this year.

Under these circumstances, the government should stop acting as a mediator in defaults and start allowing troubled companies to go under. Defaults such as Dongbei Special Steel's should be used as a precious chance to abolish the government bailout system in the bond market and correct distorted credit pricing. Only when the bond market operates in accordance with market rules, can the occurrence of systemic risks be prevented.

This is an edited excerpt of an article originally published in Economic Information Daily

Copyedited by Bryan Michael Galvan

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