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China's woes go beyond its first corporate default

China's first-ever corporate default has rattled investors around the world. Many are now noticing how much the nation's official and unofficial banks have loaned to real estate that's overpriced, manufacturing suffering from massive overcapacity and mining companies facing plummeting demand. Now, it's not just the specialists who are considering the dreaded word "bubble."

Last week's default on a bond payment by Chaori Solar Energy wasn't particularly big in terms of corporate finance -- the total bond was valued at about $14.5 million. What made it noteworthy was that it happened at all.

For years investors had assumed an implicit government guarantee on all corporate bonds. This wasn't a crazy assumption. This is China's first corporate default because Beijing, flush with cash, has for years bailed out corporations. In January the government bailed out China Credit Trust Co. for a $500 million trust product based on a failed coal mining company.

However, Premier Li Keqiang has made it clear since taking office that he wants to wean the nation's economy from its dependence on government investment.

In another troubling sign for investors, official data released over the weekend showed the steepest slide in Chinese exports since 2009. Some analysts blame the drop on the recent holidays.

"February exports are always affected by the Lunar New Year holidays," Carl Weinberg of High Frequency Economics wrote in a note to investors. "Factories close for up to six working days each year for this celebration. ... So we often see a blip downwards in exports from their trend during, just before and just after the holidays."

Others are a bit less sanguine. Although Julian Evans-Pritchard of Capital Economics believes the export totals are mostly unchanged from a year ago, he also warns, "Over invoicing -- of exports to Hong Kong and Taiwan in particular -- inflated exports early last year, providing an artificially strong base for comparison and suppressing export growth."

All this has made foreign investors considerably more risk-averse. Exchange-traded funds that specialize in the Chinese economy are pulling huge amounts of money out of the nation. According to Bloomberg, withdrawals from U.S.-based Chinese ETFs totaled $87.5 million March 10, the most among 46 nations, bringing this year's redemption to $380.7 million.

If letting Chaori Solar and other companies go it alone in the marketplace is part of Premier Li's plan, the potential losses are enormous. According to Bloomberg research, total debt of publicly traded nonfinancial companies in China and Hong Kong has more than tripled to $1.98 trillion from $607 billion at the end of 2007. Of those companies, 63 have debt-to-equity ratios exceeding 400 percent. The average is 73 percent.

Other indications show that Beijing may be willing to take the hit needed to put the world's second-largest economy on a more sustainable path. Last week, China announced an economic growth target of 7.5 percent annually -- the lowest since 1990.

Unfortunately, additional signs point to weakness in China's underlying fundamentals. For example, the overcapacity of its steel and iron industries was recently described as "beyond imagination" by one Chinese official. Although steelmakers are cutting capacity -- mostly outdated, high-polluting mills -- they're adding more capacity than they're getting rid of.

Companies are able to get loans for expansion from financial institutions scared of admitting how much they already have in nonperforming loans on their books. In the past, the government has encouraged this behavior as a way to provide jobs and avoid potential civil unrest.

This overcapacity has caused some resource prices to nosedive. On Monday, iron-ore suffered one of its biggest falls on record, and Wednesday saw copper hit its lowest price in four years.

But looming over all that is the nation's hugely overleveraged real estate sector. Guangzhou's 21st Century Business Herald reports, "the total area of completed construction of housing units in Beijing exceeded the total sale area in 2013. This means that an oversupply of houses has surfaced in the city's property market and if the trend continues, it will become a pressure to drive down home prices."

Beijing is far from alone in having a stunning oversupply, but prices continue to soar. Official figures showed prices of new commercial and residential units in prosperous cities like Beijing, Shanghai, Guangzhou and Shenzhen have surged more than 20 percent since September.

In a column released today, Yao Yang, dean of the National School of Development and director of the China Center for Economic Research at Peking University, wrote: "Liquidity-thirsty developers, unable to acquire financing through the formal banking sector, have been taking out massive loans at extremely high interest rates. But, in many cases, housing demand has not grown as expected, raising the risk of default -- the effects of which would be transmitted to the entire financial sector."

Perhaps more than any one or two companies' defaults, this is what investors should be paying the most attention to.

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