A worker cements a bench at the Loudi City Construction and Investment Co.-financed Zhu Shan Park in Loudi, Hunan Province, China. In China, subprime mortgage market in 2008, local borrowing has been backed by collateral that is overvalued, may be hard to sell and, in at least one case, doesn't exist yet. (Adam Dean/Bloomberg)

Workers toil by night lights with hoes, carving out the signs for Olympic rings in front of an unfinished 30,000-seat stadium, bulb-shaped gymnasium and swimming complex in a little-known Chinese city.

Loudi, home to 4 million people in Chairman Mao Zedong’s home province of Hunan, is paying for the project with $185 million in bonds, guaranteed by land valued at $1.5 million an acre. That’s about the same as prices in Winnetka, Ill., a Chicago suburb that is one of the richest U.S. towns, where the average household earns more than $250,000 a year.

In Loudi, people take home $2,323 annually, and there are no Olympics here on any calendar.

“The debt isn’t a problem, as Loudi is not a developed place,” Yang Haibo, an official at the city’s financing vehicle, says as he sits with colleagues in a smoke-filled meeting room under a no-smoking sign. “It’s an emerging city.”

A 3,300-mile tour of three cities in China, coupled with reviews of dozens of Chinese-language bond prospectuses that offer an unusually transparent view into local government debt, shows just how widespread such borrowing has become. In China, as in the United States before the collapse of the subprime mortgage market in 2007, local debt is backed by collateral that is overvalued, may be hard to sell and, in some cases, doesn’t exist.

Officials in Loudi, whose colonnaded government building is locally nicknamed the White House, value their 18 tracts of land at almost four times what a similar plot sold for in May. In the northeast city of Cangzhou, the man in charge of the assets financing a port expansion can’t locate the land his company posted as collateral for a 1 billion-yuan bond sale. And a spending spree in Yichun, a district on the Russian border covered by ice much of the year, is backed by promises of future land sales that officials acknowledge may never materialize.

More than 400 billion yuan of municipal bonds sold since 2008 — part of as much as 14.2 trillion yuan in local borrowing — show how much local officials rely on their own forecast that land prices will continue to rise. Efforts by the central government to cool the property market so far have had no impact on their bullish estimates.

Residential land sale values slumped 30 percent this year as local officials increased sales to pay back loans, according to Credit Suisse Group.

“It’s a huge myth that land sales are going to be able to even support the interest payments, let alone the principal payments,” says Stephen Green, the Hong Kong-based head of Greater China research at Standard Chartered. His research team assumes that as much as 6 trillion yuan of local government loans — and possibly much more — will ultimately not be repaid by the projects, Green wrote in a June 29 report on China’s debt.

Echoes of U.S. crisis

Local governments set up more than 10,000 financing vehicles in the past decade to get around laws prohibiting them from taking direct loans. One third of them don’t have cash flow to service their loans, China’s banking regulator says.

The similarities with special purpose vehicles in the U.S. hiding toxic repackaged mortgages from banks’ balance sheets are increasing. Subsequent losses prompted the U.S. government and central bank to lend, spend or guarantee a peak of $12.8 trillion in 2009 to rescue the financial industry, including a $45 billion direct investment to rescue Citigroup, then the biggest U.S. financial services company.

“It means that China is playing with fire like we played with fire when we had all those SPVs that took everything supposedly off the books,” says Carl Walter, who retired this year as the chief operating officer in China for J.P. Morgan Chase. “It didn’t take them off the books. Citibank went down.”

Moody’s Investors Service puts overall local government borrowing at 3.5 trillion yuan above the 10.7 trillion yuan stated in a national audit published June 27. China’s central bank on July 11 backed the official count, saying estimates of 14 trillion yuan were “obviously” too large.

Banks cannot restructure all the local government loans on their books, says Yvonne Zhang, a Moody’s analyst in Beijing. Recapitalizing the banks by the central government will slow growth in the world’s second-largest economy, says Vincent Chan, head of China research at Credit Suisse in Hong Kong.

The effects would reverberate around the globe in weakening the country’s appetite for U.S. Treasuries and European debt, as well as driving down prices of oil and metals, Fitch Ratings said in a June 28 report.

Touting Western brands

The building binge fueled by this mound of debt is evident a few hours’ drive into the hills of Loudi from the provincial capital of Changsha. Cranes abound amongst new high-rise apartment complexes with names like Wealthy City, surrounded by billboards showing pictures of Caucasian women strolling through shopping malls featuring brands like KFC and Microsoft.

Loudi City Construction Investment Group plans to use 21 percent of the proceeds from its bonds issued in March for the stadium complex and the rest for a new expressway into town, water treatment facilities and a park, according to its prospectus. The city is one of scores across the country building roads, commercial centers and subways after being urged to spend their way out of the 2009 global recession.

On a sunny day in early June, Yang smiles as he talks of transforming Loudi’s economy from one dominated by a single state-owned steelmaker into that of a bustling transport hub, a popular phrase these days with officials who tout projects they say will bring prosperity to their cities.

Set on a lush green hillside, Loudi will be a stop on a high-speed railway spanning more than 1,200 miles from Shanghai in the east to Kunming in the west, near the border with Burma.

“Every train will stop here,” says Yang, in his downtown office at the company’s headquarters. A Mao statue with a red kerchief draped around its shoulders stands in the lobby.

Outside, Yang points to a vacant plot in a swath of land already cleared and being drained to build apartment blocks. It’s one of the lots being used for collateral.

The company has pledged to repay debt by selling land it received from the city, leveraging local land prices that doubled between 2007 and 2010, according to the prospectus. The 9.69 million yuan an acre it values its land for the bond compares with a tender price in May of 2.54 million yuan an acre for a city plot zoned for commercial use, according to data from the local State Land Resources Bureau.

Better than Treasuries

Foreign ratings companies don’t assess China’s local bond market and domestic evaluations vary. Beijing-based Dagong Global Credit Rating rates Loudi’s bonds at its fourth-highest investment grade, one level higher than it gives to U.S. Treasuries. That’s in spite of its own December 2010 report that said: “The city’s ability to balance the general budget is decreasing and the results of the sales of land use rights will impact the company’s ability to invest and do construction.”

Dagong gives a high rating to the bonds of local government financing vehicles because the central government has said infrastructure debt will be repaid by local authorities, chairman Guan Jianzhong said July 11. Rapid growth in local fiscal revenue should enable them to pay debts, he said.

Loudi’s investment vehicle had a negative operational cash flow of 187.1 million yuan in the first half of 2010, a period during which it borrowed 284 million yuan. Beijing-based China International Capital Corp., often referred to as CICC, gives Loudi its third-lowest rating, a speculative or non-investment grade.

The yield on Loudi’s bonds reached a record high of 7.318 percent on July 7, according to data from China Foreign Exchange Trade System.

Yang, the official, isn’t worried. “When we get to the end of our loan, we’ll just pay it back,” he says.

Across China, cities increasingly turned to the country’s nascent bond market last year after the national government turned off the spigot for many bank loans. That’s propelled a six-fold increase in bond sales this year from three years ago, according to CICC, an investment bank run by the son of former premier Zhu Rongji.

“We are forecasting a lot of local governments will have to default,” says Jinsong Du, an analyst at Credit Suisse in Hong Kong. About one-quarter of China’s municipal debt is guaranteed with land sales revenue, Auditor General Liu Jiayi said.

Mansions among smokestacks

In Cangzhou, almost 800 miles northeast of Loudi, on the shores of the Bohai Gulf, luxury apartment complexes are sprouting up in view of more than a dozen smokestacks at one of China’s biggest coal depots. A billboard for Leader Mansion promises, in English, that it will bring the buyer a “high degree of endorsement of a city life.”

The city is expanding Bohai New Area, a port zone between Tianjin and the border of Shandong province, by building roads and developing unspecified “green” projects with 1 billion yuan in bonds issued in May by Hebei Bohai Investment Co. They’re guaranteed by five tracts of land the company says is valued at more than 1.54 billion yuan, or 462 yuan per square meter. That’s more than three times what it paid the local government in December 2009, according to the company’s land use permits.

Ask Lu Chunjiang, a Communist Party member and head of the local investment company’s asset management department, where his assets are and he can’t say.

“It’s somewhere north of town, I don’t exactly know where,” Lu, 41, says in his second-floor office in Huanghua Port, built on saline marshes. “It’s like the land outside the city, you know, with the big piles of salt.”

Hebei Bohai’s bonds were skewered by Xu Xiaoqing, head of fixed income research at CICC, in a May 26 report.

“This issuer’s own profit and cash flow is very little, its cash shortage is extremely big, its debt load is very heavy, and it doesn’t possess the ability to pay this bond,” Xu and his team wrote. The local government’s fiscal income “is very limited, there will be a lot of pressure on it to support the payment of this bond,” they added.

Hebei Bohai’s long-term debt of more than 7 billion yuan at the end of 2010, before the bond was issued, was greater than the city’s annual revenue of about 5 billion yuan for that year, according to the prospectus.

The debt-to-government revenue ratio was higher than that of Vallejo, the northern California city that filed for bankruptcy in 2008. Vallejo cited falling revenue from real-estate transactions as a reason for its bankruptcy.

Banks on the hook

Banks including Industrial & Commercial Bank of China and China Construction Bank Corp., the country’s two biggest by market value, may have problematic loans equivalent to 30 percent of their books, says Victor Shih, a professor at Northwestern University, who studies China’s local government debt.

The banks also are among the leading holders of China’s mushrooming corporate debt, according to data compiled by Chinabond, China’s Beijing-based bond clearing house. This year, mutual funds have been the biggest buyers, according to CICC. They’ve snapped up half the corporate bonds issued in the first five months of this year, 70 percent of which were to finance local government projects.

Buyers are attracted to high yields and have faith that the central government will bail out any in trouble, says George Weisi Tan, head of bond investments at Fortune SGAM Fund Management Co. in Shanghai.

“They think the interest is risk free,” says Tan, who says some brokerages leverage themselves by as much as three times their capital. “This is really a big systemic risk.”

Such pessimism is overblown, says Nicholas Lardy, a senior fellow at Washington’s Peterson Institute for International Economics who specializes in China’s financial system. The buildup of debt is slowing and many local infrastructure projects will raise revenue and add to economic growth, he says.

“A majority of the projects that are being undertaken by these companies are probably projects that have very high economic rate of return,” Lardy says.

Wang Tao, a Beijing-based economist for UBS, wrote in a June 7 report that a crisis from bad local debt is “unlikely in the near future.”

Of most concern, she said, is borrowing obtained with no collateral at all.

That’s the case in Yichun, a Maryland-sized area of about 1.3 million people deep inside the birch and pine forest on China’s border with Russia.

Yichun is a poor city in a poor province. The income of its residents was little more than half the national average last year. That hasn’t stopped the government from going on a spending spree. The new local police headquarters has a miniature dome reminiscent of that of St. Peter’s Basilica in Vatican City.

‘Shanty towns’ bulldozed

Yichun City Construction Investment & Development sold 1.2 billion yuan in bonds in 2009, backed only by a pledge from the local government and possible future land sales. CICC gave it the lowest debt rating of any city financing vehicle. In contrast, Dagong rates the bonds one level higher than U.S. debt.

Money raised from the sale is being used for the destruction of what the prospectus calls “shanty towns.” Single-floor traditional wooden homes in the valley are being demolished to make way for thousands of low-income apartments. The company has also financed a new reservoir, an airport terminal and parklands, one featuring faux Corinthian columns topped by winged warrior princesses and bronze sculptures of chariot-riding local gods.

Wang Zhongbing, 77, a retired factory worker who spends the summer days chatting with friends in a park next to the Yichun River, says the economic development is passing his family by. Only one of his three adult sons has a job, he says.

“I miss Chairman Mao,” says Wang, sitting on a red plastic chair in front of a billboard for newly built Pinaster Town, featuring a picture of a woman in high heels stepping out of a Rolls-Royce. “The common people cannot afford these houses.”

The Yichun financing vehicle would have lost money every year from 2006 to 2008 except for direct government subsidies. At its offices above a local bank branch in the center of town, Sun Yunlan, 49, who according to the prospectus is deputy general manager of the company, referred questions to the city’s finance department, which, in turn, referred questions back to the company.

The prospectus promised that land from the city “will provide a more substantial cash flow.” Two years on, that hasn’t come to pass, according to Wu Liangguo, the head of the Yichun City Bureau of Land and Resources and its Communist Party secretary.

“The land market in Yichun isn’t that great,” says Wu, 49, who jogs even in the chill of the Siberian winter. “The local government financing vehicle may get land in the future but it isn’t a certainty.”