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Is the Evergrande bankruptcy affecting the US stock market?

US stocks took a tumble this week after news that Evergrande, may default on millions of dollars of debt owed to US financial institutions and investors.

US stocks took a tumble this week after news that Evergrande, may default on millions of dollars of debt owed to US financial institutions and investors.

The Evergange crisis is begining to worry investors in the US as the company declares bankruptcy and shows few signs of being able to pay its debt. 

While the company had been acquiring the debt for many years, it was not until 2020 that its finances came under scrutiny.

In 2020, to avoid a financial collapse, like the one seen in the US in 2008, the Chinese government enacted restrictions on the amount and types of debt a company could hold. Evergrande quickly violated these restrictions, meaning that they would no longer be able to acquire more debt, which sent the company into a tailspin.

How did the company acquire so much debt?

For decades the company had survived by attracting investments -- or debt -- into commercial properties that would then be sold to repay investors.

However, as the Chinese government began to investigate the company's financial records, it became clear that the business model would not be able to support the full repayment of their debts. The company had inflated the values of thier properties, which created a false picture of financial solvency. In the end, the Evergrande was selling their properties at prices far below what their records showed, putting them in the red, and thus reliant on the acquisition of more debt to keep their doors open.

What does it mean for investors if the company defaults?

On Thursday 23 September, Evergrande was on the hook to pay $83.5 million in interest payments. It did not meet the deadline. On 29 September, the company is required to pay an additional $47.7 million. Lucky for Evergrande, they have a thirty-day grace period before they default on their debts, but already investors are concerned that there could be far-reaching impacts across global markets. 

For investors and banks who own pieces of the companies debt, many of their concerns stem from the idea of “contagion.” In the financial world, contagion refers to the effect that one default has on the obligations of other investors or institutions.

Say, a bank is owed $40 million dollars from Everglade, and those debts are not paid. Well, if this bank is indebted to another company and cannot make those payments, a default cycle could begin to propel through the economy. Such a phenomenon could lead to a liquidity crisis, where it becomes harder to acquire loans.

Impacts on the US stock market

One of the biggest issues with this crisis is timing.

Throughout the pandemic, many governments and central banks have had to use massive amounts of public spending to avoid total collapse. With so much money out the door, there is less to rely on to help stabilize the economy should there be serious fallout.

The S&P 500, a key indicator used by investors to gain insights into the standing of the market dropped around five percent from 2-20 September. However, this was not all due to the Evergrande crisis. The United States stock market has fared well throughout the pandemic, but as federal stimulus spigots are turned off, the market could suffer.

After a slow job report in August, the ending of federal unemployment benefits, and the chances of a fourth stimulus check to dwindle, investors are predicting that the tide could make a turn for the worst. All of this of course happening in parallel to a surge in covid-19 cases from the more contagious Delta variant; a reminder that the public health crisis is far from over, and continues to threaten the economic recovery.

The Communist Party in China has made efforts to mitigate a total collapse, like injecting over $18 billion into the financial system to avoid liquidity shortfalls. However, the Chinese government has not shown interest in bailing out Evergrande. Chinese leaders and many critics of the US financial system share a similar idea that bailing out the company could create perverse incentives for other companies to over indebt themselves thinking the government would come to their rescue.

During the 2008 Financial Crisis, the US government did bail out various banks, to avoid an economic depression. But some economists believe that many of these companies were not penalized nearly enough to avoid them using the same practices that could lead to the same issues in the future.