The overall context of the markets works in favor of an intense dollar scenario in 2022.

In September, the markets’ attention by two topics – the financial situation of developers in China actions of the Fed. 

Evergrande is a consequence of the introduction of new regulations in the real estate segment by the Chinese authorities, which may affect many players given that the bulk of finance was attracted by these companies in the domestic rather than foreign markets, at the moment the situation looks manageable. 

On the other hand, the Fed ignored investors’ concerns about the situation in Asian markets and gave a harsh commentary, indirectly hinting at the possibility of rate hikes already in 3Q22. Thus, the overall context of the needs works in favor of an intense dollar scenario in 2022.

The situation in the construction sector brings investors’ attention back to China: The situation in China has been little discussed by global investors lately, and since 2020, after the global economy has entered a phase of recovery, the attention of the markets has turned to the United States.

In China, however, significant efforts have been made in recent months to tighten developers’ financial position regulation, leaving China’s second-largest developer, Evergrande, in financial trouble.

 Following a meeting of departmental commissions in Beijing on August 20, the Chinese authorities decided to introduce maximum standards for the financial performance of these companies, called three red lines – (1) the ratio of liabilities minus advance payments to assets should not exceed 70% ( 2) net debt to equity should not exceed 100% and (3) the ratio of cash to short-term debt should not be less than 100%. Significantly, all three of these indicators have shown significant deterioration since 2016.

• Exceeding one of the specified standards will force companies to limit debt growth to 10%; 
• Exceeding the threshold for two ratios will limit debt growth to 5% if the points for all three ratios companies will not increase debt levels to levels exceeding June 2019. 
• And even those companies that have not reached the limit levels for all three standards will still not be able to increase their debt by more than 15%.

Tightening of regulation does not seem to be associated with excessive lending growth – the growth of the loan portfolio of developers in China has slowed from 10% in 2019 to the current 8%. Instead, concerns are associated with a possible increase in construction volumes – home sales in the last months of this year show a slowdown, and prices for new homes are now growing at the highest rate over the past 11 months.

Markets are concerned about Evergrande’s financial position and the risk of discrimination against foreign investors in debt restructuring: Of the 334 developers subject to the new regulation, 50 exceed the norm on all three criteria, and this group accounts for about 40% of the sector; another 62 companies, which account for about 20% of the industry, do not meet two of the three standards.

Evergrande accounting for 4% of all property sales in China, was initially in the most vulnerable position. It did not comply with all three regulations and announced significant price cuts for its properties to improve its finances by selling a part portfolio of its portfolio real estate. 

However, by September 20, the company’s ability to meet its financial obligations became a severe concern for global markets. The total financial liabilities of Evergrande are $ 600 billion, of which $ 300 billion is in market instruments. The good news is that domestic investors hold the overwhelming majority of debt obligations, and the default on these obligations does not directly impact world markets.

 About 50% of Evergrande’s financial attraction comes from Chinese trust funds and 25% from Chinese banks. Nevertheless, about $ 20 billion is the company’s debt to foreign investors. The primary concern of the markets is the company’s ability to provide a level playing field for restructuring to Western and Chinese investors.

If the approach to debt to foreign investors is discriminatory, there is a risk of capital outflow from financial instruments of other Chinese developers. Considering that Evergrande’s weight in the Bloomberg Barclays Asia index is only 1.6%, the share of all Chinese developers in this index reaches 30%. And even if at the moment the markets digest the restructuring of Evergrande, should remember that the list of Chinese developers facing problems under the new regulation is quite long.

The unfavorable situation in Asian markets gave investors hope that the Fed could postpone tightening its monetary policy, but this did not happen. Instead, in his speech on September 22, the head of the FRS announced an imminent transition to a reduction in the growth rate of the balance sheet (tapering), which is expected to begin in November this year (the next Fed meeting on November 2-3) and will last mid-2022.

The updated forecasts from the Fed indicate that inflationary pressures will persist not only this year but also next year – the forecast for the PCE indicator, the dynamics of household spending, was raised to 3.7% this year and to 2.3% in 2022. Against this background, the Fed’s communication opens up the possibility for the first-rate hike in 3Q22 – at the moment, the Fed’s materials suggest a slight increase by 25 bp. etc., but the forecast level of the rate for 2023 was increased from 0.6% in June to 1.0% now.

Of course, the Fed’s willingness to adhere to just such a plan of action will be constantly confirmed by actual indicators of the state of the economy, in particular, by the state of affairs on the labor market. That is why the publication of data on the unemployment rate (5.2%, according to the latest data in August) and job creation (235 thousand in August) will be the main objects of market attention in the coming months.

The Fed’s rhetoric can be considered relatively hawkish. The only reason it does not lead to a correction is that even with the beginning of tapering on the horizon of next summer, the Fed’s balance will still grow by another $ 1 trillion from the current level.

 At the same time, one should expect the solid dollar to remain on world markets and the movement of the euro/dollar pair from the current levels of 1.17-1.18 to the interval of 1.1-1.15, which looks more justified for 2022.