HANGZHOU - The insolvency of a property developer in East China's Zhejiang province has shed light on the risk in China's formerly red-hot real estate sector.

Due to the slowing economy, tightened lending and market expectation of a moderation, China's home prices have seen smaller gains in large cities recently. But in some smaller cities, the housing market has cooled considerably, with sales tumbling and prices stagnant or declining.

The cooling took its toll on the Zhejiang Xingrun Real Estate Co based in the city of Fenghua as it failed to pay off a total of 3.5 billion yuan ($565 million) in debts.

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Xingrun owed the debts to 17 banks, two micro-credit companies, 99 individuals as well as some contractors, said Chen Yonghui, deputy director of the general office of the Fenghua municipal government and member of a government group formed to help settle the debt issue.

From late last year, Xingrun started to see defaults as its capital chain broke, said Chen. "Latest investigation showed that Xingrun has become insolvent with liabilities exceeding assets."

The company's owner and legal representative have been arrested and put under criminal investigation for alleged illegal absorption of public funds.

Defying tightened bank lending, Xingrun turned to private loans to help maintain normal operation, but high lending costs and property market cooling made defaults unavoidable, Chen said.

According to the official, the group is in talks with creditors to seek solutions but may ultimately need to go through bankruptcy liquidation.

Xingrun has attracted widespread media coverage as it could become the country's first real estate developer to go bust this year. Also, many are closely watching to see if the government will bail it out or allow it to go bankrupt.

Experts say its collapse has highlighted the risks for real estate developers, particularly smaller ones in the third- and fourth-tier cities, where a cooling market is starting to bite.

After years of housing curbs, many third- and fourth-tier cities have seen declining transaction volumes and some have even showed signs of excess supply, said Cheng Weiming, chief analyst with kfw001.com, a real estate information service website.