Looming debt defaults mark turning point for China

China's ruling party has spoken: The money-lending party is over.

In response to an historic lending boom that has saddled China with too much of everything from unsold real estate to underused mines and factories, the government in recent weeks has sent a clear message to lenders and borrowers: The days of easy credit are over.

The move comes as China's $9.4 billion economy show signs of a slowdown after a borrowing-and-spending spree that left behind billions of dollars worth of bank write-downs and the restructuring of billions more in failed and troubled loans in money-losing companies.

Brent Lewin | Bloomberg | Getty Images

High-rise construction projects in the Zhujiang New Town district of Guangzhou, Guangdong Province, China, March 26, 2014.

While the investors holding these bad bets lick their wounds, it's not at all clear whether the damage from these losses is contained—or represents a wider risk to China's financial system. But most observers agree there is a lot more air to be let out of China's lending bubble.

"You're going to see more and more of these companies default and go bankrupt because I think there is still a lot of overcapacity in the economy," Kelvin Tay, a UBS investment manager based in Singapore, told CNBC. "The government is going to instill more discipline among investors and lenders; they're not going to bail out every one of these companies that have run into trouble."

The new, tougher credit policy has been in the works since Xi Jinping was installed as president last fall at the Communist Party Central Committee's third plenary session. But the impact of the financial reforms has been felt intensely in just the last few weeks.

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In mid-March, Shanghai Chaori Solar Energy Science and Technology missed an interest payment, becoming China's first-ever domestic bond default. The government's hands-off approach marked a key turning point for investors who had long assumed that such offerings came with an implicit state guarantee.

Lest no one misunderstand the new policy, Premier Li Keqiang warned that China's economy faced "severe challenges" and that further defaults would be "hard to avoid."

The new "no bailout" policy is one more step in China's long march to transform itself from a largely agrarian economic to a modern, developed nation. Set in motion more than 30 years ago by the late Deng Xiaoping, the plan has sparked the largest migration from farms to cities in human history, the construction of tens of thousands of miles of roads and railways and billions of square feet of new real estate. Last year alone, construction was underway on enough residential and office floor space to cover an area more than twice the size of Rhode Island.

Much of the money to finance that construction was showered on the Chinese economy in the aftermath of the global financial collapse in 2008, as governments around the world scrambled to fill the giant money hole created by an epic string of bad bets on U.S. mortgages.

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In China, thanks to a tight web of political connections between lenders and borrowers, along with close ties between banks and state-owned companies, a lot of the money was misspent. Now, as Beijing's new leaders try to clean up the mess, they're undertaking high-profile anti-corruption sweeps and signaling that failing businesses and investors holding bad loans can no longer rely on bailouts.

There are plenty of candidates for default, starting with billions of dodgy investments made by trusts that have become popular havens for China's wealth. In the last year, more than $4 billion worth of holdings in real estate projects, mines, factories and other assets has gone bust or been restructured, according to recent reviews of published reports by analysts at Deutsche Bank and BofA Merrill Lynch.

China's biggest banks wrote off more than $9.5 billion in bad loans last year, more than double the year before, according to by the Financial Times.

But with its economy slowing, some observers wonder whether China's technocratic leaders can successfully engineer a "soft landing" as they try to put the brakes on an era of go-go lending.

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"They are clearly are allowing a bit more air out of the system—they have to. But it's really a risky process," said Maarten-Jan Bakkum, a market strategist with ING Investment Management. "If you really allow overcapacity companies to go bankrupt, if you let corporate bonds default, that means that you risk a bigger systemic crisis."

That uncertain outlook has weighed on financial markets around the world, and focused attention on the potential impact of a wider restructuring of China's bad debts.

Still, China has built an enormous financial cushion to weather any coming credit storm: some $3.8 trillion in foreign exchange reserves at the end up last year, the largest in the world. And while economic growth is slowing, China's trade surplus with the rest of the world rose 13 percent last year to $260 billion, the highest since the Great Recession.

Those financial resources, combined with China's tightly managed brand of "state capitalism," should help buffer the impact of looming defaults, according to Paul Donovan, global economist at UBS Investment Bank in London.

"If anything even begins to look like a systemic problem, it's not allowed to happen," he said. "Trusts in difficulties? No, absolutely not. An obscure company that no one's ever heard of gets paid 90 cents on the dollar? Yes, because that shows that we're keen on (reform)."

But even if the financial system can stand up to the coming stresses, China's slowing economy and tighter credit present an even bigger challenge for Beijing's new leaders.

Until recently, popular discontent with corruption, pollution, wealth inequality and other social strains have been eased somewhat by the longer-term progress in lifting a billion citizens out of poverty.

As growth slows, Beijing's leaders can't afford to slow the spread of the fruits of Deng's reform plan to the Chinese people.

"They've got some tumultuous times ahead, and they're not going to be growing to 7.2 percent—although they'll tell the world they are," former Honeywell CEO Lawrence Bossidy told CNBC. "When the growth slows, it's going to cause internal turmoil. They're going to get through it. They have big some reserves. But they'll have tougher days. "

—By CNBC's John Schoen. Follow him on Twitter @johnwschoen or email him.