Changzhou, a city of 4.7 million people in the Yangtze River Delta area, is most famous for its ghost city, one of many ghost cities in China, product of a ludicrously overheated, self-reinforcing, debt-driven property and construction bubble, powered by local governments’ limitless ambitions and hunger for revenues and by developers who took the money that grew on trees and plowed it into the ground.

What remains now is a simple question: Who would ever live in these luxury homes?

Rather than waiting for some unlikely miracle, the Changzhou Daily – a Communist Party rag, so this is the trusty government speaking – ran a front-page article that exhorted citizens to buy homes in the ghost city. The article proclaimed (via China Real Time) that it was “a good time to purchase real estate.” So prices in the ghost city had dropped 5.8% from a year ago and sales in the first half had dropped 11.3%, the article admitted, but what the heck, there is “no downside for home prices in our city.”

That’s how bad it is.

And the companies that made these ghost cities and other worthy projects happen? They borrowed money without limit, they mortgaged, re-mortgaged, hypothecated, and re-hypothecated whatever assets they might have had to build and profit without limit. Now the dominos are beginning to fall.

Huatong Road & Bridge just warned that it may default on both interest and principal on 400 million yuan in one-year bills that mature July 23. The announcement blamed it on the chairman who, tangled up with authorities, is currently “assisting an official investigation.”

Active in the construction and property industries, the company has fallen on hard times. You can build only so many ghost cities before you become the laughingstock of the world, and now home prices are declining, and the infrastructure spending spree has run its course. The fact that the company was able to issue the debt in July last year, that it found buyers for it when everyone already knew that the China housing and construction bubble was in the uneven process of imploding – variously, despite and/or because of government actions – was a sign of just how blindly these investors trusted the notion that the government would always bail them out. They knew you couldn’t lose money in bonds.

If the default is allowed to occur, it would be the first such publicly announced default in the interbank market, China’s largest bond market, and the first default on both interest and principal due on a bond, Reuters reported.

In March, Shanghai Chaori Solar Energy Science & Technology defaulted on 89 million yuan in interest payments due on a bond that traded on the smaller Shenzhen exchange. That was China’s “first publicly known default,” as Reuters called it, and it rattled the markets. New issues were put on hold. Yields on riskier issues jumped as investors began shifting their money into bonds they thought were better protected by implicit government guarantees.

Until then, it was assumed that all debt would somehow get bailed out by the government via its state-owned megabanks or other mechanism. They could roll over the debt forever, rather than acknowledging that the money has been plowed into the ground without returns and without possibility of ever earning enough to service the debt.

China’s credit ratings agencies were right on top of it. Like their American sisters, they down-grade after a potential default is announced. This is very helpful for investors who’d bought this crap earlier. So after Huatong’s announcement, China Lianhe Credit Rating downgraded the outfit to BB-plus from AA-minus with negative bias, and the bond that might default next Wednesday to B from A-1.

Companies exposed to China’s gargantuan property, construction, and infrastructure sectors are in trouble. Their credit metrics have been deteriorating. Other sectors are in trouble as well. Domestic auto brands are getting clobbered by foreign brands. Industrial overcapacity has reached crisis proportions. Local governments have borrowed out the wazoo and on the sly to fund their building binges. This ballooning debt was central to China’s growth. But many of these investments have turned into mal-investments and unrecognized losses.

And now China is drowning in an unknown sea of bad debt that is being rolled over, rather than cleared up through defaults or other forms of write-downs, and so the implicit losses are being rolled over too. Via its highly centralized decision-making process and a banking sector that is controlled by the state, authorities have been able to prevent legal defaults and push this system to extremes unimaginable in other countries.

But bad debt and implicit losses don’t just evaporate. They’re all still there, unresolved, useless, worthless, an “asset” on some set of books – the balance sheets of state-owned banks, for example – and an albatross around the neck of the economy.

In the end, these losses will have to be eaten. In free markets, equity holders, bondholders, and other creditors would swallow them lock, stock, and barrel. In central-bank or government manipulated markets, losses are transferred to savers via financial repression (preferred in the US), to taxpayers via direct bailouts (Europe excels at this), to consumers and workers via inflation, to a combination…. You get the idea. And that’s when reality returns to China. Read…. Who Will Be Assigned To Eat The Losses ‘Hidden’ On China’s Balance Sheets?

 

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