* Chaori says can't make 89 mln yuan interest payment due Fri
* Default would be first-ever in China's domestic bond market
* Chaori narrowly avoided default in Jan 2012
* China's solar industry battered by overcapacity
(Recast, adds detail and background)
SHANGHAI, March 5 (Reuters) - Loss-making Chinese solar equipment producer Chaori Solar said it will not be able to meet interest payments on bonds due on Friday in what would be the country's first-ever domestic bond default.
The warning by Shanghai Chaori Solar Energy Science and Technology Co Ltd highlights the rising credit risk in China, where record levels of corporate debt are likely to accelerate a spate of restructuring and trigger more defaults.
Chaori Solar is obliged to pay 89 million yuan ($14.5 million) in interest on Wednesday on 1 billion yuan worth of bonds issued in 2012 but it said it will only be able to pay 4 million yuan.
"As such, the company will not be able to fully pay the interest on the 'Chaori-11 Bond' in time on March 7," the company said in a statement posted on the Shenzhen stock exchange website late on Tuesday.
Bond defaults are rare in China as the government has tried to keep the country's debt bubble from bursting and dragging the economy down with it.
Chaori narrowly avoided a previous bond default in January 2013 after a local government in Shanghai persuaded banks to defer claims for overdue loans which enabled the company to meet its bond interest payment.
This time, however, a last-minute solution appears less likely.
The Shenzhen stock exchange, where Chaori's bond trades, requires issuers to notify investors two days in advance of scheduled payments. Chaori's notice late on Tuesday indicates it is already resigned to missing the deadline.
Chaori, however, said it was working to secure the funds necessary to pay out investors in full, raising the possibility the interest payment may occur after a delay.
The bond matures in March 2017 and carries an interest rate of 8.98 percent.
DEFAULTS "A GOOD THING"
China is still waiting for its first-ever domestic bond default, although Chinese markets were on edge last month when a high-yield investment product issued by China Credit Trust Co Ltd warned it may not pay out on maturity.
That product eventually paid out principal, though not interest, after an unnamed white knight stepped in, but a few days later, another high-yield product issued by Jilin Province Trust failed to pay out on schedule.
Both trust products were based on loans to deeply indebted coal companies.
Analysts say a default could help reduce the moral hazard caused by the widespread assumption that corporate bonds enjoy an implicit guarantee from the government and state banks.
This assumption has allowed even weak companies to borrow at low cost, leading to excessive debt and wasteful investment.
"We think it's a good thing as a normal economy needs those defaults to better price bonds and other debt products," Lu Ting, China economist for Bank of America-Merrill Lynch in Hong Kong, wrote in a note to clients on Wednesday.
"We believe the chance of some bond and trust loan defaults will rise significantly in 2014, especially as the more confident government sees the need for some defaults to develop a more disciplined financial market," Lu added.
Defaults on offshore bonds issued by Chinese firms have occurred before. LDK Solar Co Ltd's missed several interest payments on offshore U.S. dollar bonds last year.
China's solar industry has in recent years suffered from severe overcapacity and falling prices for photovoltaic cells, while the government has been embroiled in a trade war with the United States and the European Union
Chaori on Friday reported a net loss of 1.33 billion yuan for 2013, less than its loss of 1.68 billion yuan in 2012. But the operating income fell by 60 percent in 2013, in a sign of its ongoing struggles.
($1 = 6.15 Chinese yuan)
(Additional reporting by Umesh Desai in HONG KONG; Editing by Miral Fahmy)