It is generally accepted by Western analysts that China makes up most of its economic statistics -- which is only reasonable when you consider what it would take to actually measure an economy of a billion people working for a mix of state-owned and private companies divided between chaotic mega-cities and distant rural farms.

But lately the fake number theme is showing up more often in the mainstream press, which is interesting. Consider this from Bloomberg on a segment of the Chinese economy that doesn't generally get much attention:

China Corporates Not Making Debt Payments

Chinese corporate debt was 113% of gross domestic product at the end of last year according to the widely followed Louis Kuijs of Royal Bank of Scotland. That's worse than the 86% in 2008. J.P.Morgan thinks the 2012 figure was 124%, and BBVA, the Spanish bank, estimates almost 130%.

All these figures, in reality, are far too low. They are based on official GDP statistics, which grossly overstate China's output. Make the proper adjustments to nominal GDP for inflation--this change by itself takes more than a trillion dollars off the 2012 results--and eliminate obvious fakery, and these percentages become astonishingly high, perhaps approaching 155%.

Will China's corporate obligations trigger a nationwide crisis? "The level of debt is not a good judgment of whether a country has a serious problem," said UBS's Wang Tao in July. "The issue is whether it can afford the debt, and so far China can."

So far, Ms. Wang has been right. Yet simple arithmetic indicates the country will suffer a wave of corporate defaults soon. As Tom Holland of the South China Morning Post tells us, "China Inc.'s balance sheet is flashing danger signals." Specifically, Holland reports that Gillem Tulloch of Forensic Asia, a research firm, notes that the 1,500 largest public Chinese companies by sales have debt that is nearly seven times their annual operating cash flow. A healthy level is about three or four, he says, and the danger line is six.

Moreover, there has been a sharp deterioration in the condition of Chinese companies. Net debt of the corporate sector was 30 times net earnings in 2012, up sharply from 10 times in 2011.

With profits falling and debt increasing, the ability of China's corporates to meet obligations will deteriorate quickly. Already free cash flow is severely negative, a "very rare" occurrence, seen in Asia only in the months preceding the 1997 financial crisis.

Analysts, focusing on "ghost cities," believe China's debt crisis will begin with the notorious LGFVs, the local government financing vehicles. Now, however, there is a growing appreciation that Chinese companies, both gargantuan state-owned enterprises and smaller private firms, could be the trigger.

China's steel sector is perhaps the country's most troubled. It has run up $490 billion of debt in building mills that now account for 66% of global production. Beijing, however, overbuilt. The country currently has about 300 million metric tons of excess capacity, almost twice the output of the European Union.

Overcapacity, inevitably, has led to defaults, but only on the periphery of the industry. Steel traders, especially in Jiangsu province, have not been able to make payments, and in April Citic Trust Co. auctioned debt from a steel-related trust that failed to pay interest and principal.

At first glance, the failure of a major steel concern seems unlikely, in large part because of Beijing's long-term support for the industry. It is true that reformist Premier Li Keqiang wants to close marginal mills, but most observers believe his initiative will get nowhere beyond the shuttering of one or two small operations. After all, attempts by his predecessors to eliminate capacity have been spectacularly unsuccessful due to local resistance.

In light of all this, even Li Xinchuang, president of the official China Metallurgical Industry Planning and Research Institute, believes there will be at least one default within a year because of the inability of companies to refinance.

Failures of major companies, some believe, could domino the sector. That seems hard to believe, but the March bankruptcy filing of the main subsidiary of Suntech Power, the world's largest maker of solar panels, looks like a sign of what can happen in the steel industry. The filing is a warning because Suntech's solar panels, like steel, enjoyed deep central government support that led to massive overcapacity. The problems in steel and solar are evident across the heavy-industry landscape. Coal and aluminum enterprises now look particularly vulnerable, for instance.

Analysts, therefore, are apprehensive. Christopher Lee of S&P in Hong Kong expects an increase in corporate defaults in the next six to twelve months. Zhu Haibin of J.P.Morgan notes corporate debt is the firm's "No. 1 concern." "Recession is inevitable," says Forensic Asia's Tulloch. "China has to have an economic contraction to cleanse the system."

Chinese technocrats have been able to avoid system-cleansing contractions. The last one, according to the National Bureau of Statistics, occurred in the year Mao Zedong died, 1976. In reality, the economy plunged at the end of 1990s, and it is on the verge of recession now, if it has not already tipped into one.

At the moment, Premier Li, in an attempt to avoid a contraction, has ordered the People's Bank of China to flood the economy with cash. The central bank began injecting liquidity on June 21--in secret--and has continued since then, both publicly and surreptitiously.

Liquidity injections seem unnecessary if official statistics are accurate. But large industrial enterprises, the pride of Beijing, are running short of dough and are now paying their obligations in cash substitutes such as bankers' acceptances, which are essentially promissory notes. The Financial Times reports that one car parts company in Shanghai receives payment for about two-thirds of its receivables in these instruments. Therefore, the firm doesn't have cash to pay its suppliers. The FT was shown one acceptance, for a little more than a million yuan, which originated from a car company in Jilin province and which had been used twice for payment.

The practice has mushroomed--the amount of outstanding acceptances was just 3% of GDP in 2008 but reached 11% last year. In an environment where effective interest rates are skyrocketing--corporates are now paying an average of about 8%, up from 0% two years ago--all it takes is just one company in a payment chain to default in order to start a cascade from one province to another and one sector to the next.

Some thoughts

This article is even more apocalyptic than its title implies. To extract a few data points: China's corporate debt has risen from 86% of GDP to 155% since 2008; "Net debt of the corporate sector was 30 times net earnings in 2012, up sharply from 10 times in 2011"; and "free cash flow is severely negative." These are some serious trend reversals.

Using IOUs to pay bills is exactly the same thing as borrowing the money, in the sense that it creates an obligation that eventually has to be satisfied with cash. So "acceptances" rising from 3% to 11% of GDP is a helluva jump in private sector debt. It's not clear whether the analysts quoted above are counting this in their other totals.

Given China's opacity it's hard to know how much faith to put in these numbers in any event, but the fact that they were compiled by analysts whose job it is to get at the truth (as opposed to government officials who have been ordered to report favorable numbers) means they're probably somewhere in the ballpark.