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Will the Bank of Israel Succeed Once Again to Stop the Shekel from Strengthening? June - 2013

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Will the Bank of Israel Succeed Once Again to Stop the Shekel from Strengthening? June - 2013 The Economic Sector Will the Bank of Israel Succeed Once Again to Stop the Shekel from Strengthening? June - 2013 In May 2013 the Bank of Israel (BoI) cut its interest rate by 50bps in two separate moves. First, the BoI announced on May 13, 2013 an interest rate cut of 25bps outside the regularly scheduled framework of interest rate decisions, effective as of May 17, followed by another cut of 25bps to June’s interest rate, announced in the regular format on May 27. As of early June 2013 the interest rate of the BoI stands at 1.25%. The decision of the monetary committee to cut the interest rate in May came against the backdrop of a number of factors: (1) the continuing trend of appreciation in the shekel, (2) the initiation of natural gas production at the “Tamar” gas field, (3) interest rate cuts by many central banks, notably the European Central Bank, (4) the continuation of quantitative easing in major economies worldwide, and (5) the downward revision in global economic growth forecasts. In tandem, the BoI announced it would renew its intervention in the local foreign exchange market in order to offset the impact of newly initiated gas production on the balance of payments and its potential influence over the exchange rate. In this essay we will discuss the reasoning, in our opinion, behind the appreciation in the shekel and the degree of effectiveness of the monetary steps implemented by the BoI. The explanation for June’s interest rate cut decision involved, among other things, the desire to narrow the interest rate differentials between the BoI rate and those of the main economies around the world, with the goal of weakening the factors strengthening the shekel. It should be noted that investments by non-residents in short-term government bonds (on which the tax exemption for foreign investors has not been cancelled) indeed increased since the second half of 2012; however, in an analysis of the correlation between the effective exchange rate1 and between the interest rate differentials between Israel and the world2, as can be seen in following chart, there is a notable disconnect between these variables. 1 The exchange rate of the shekel vis-à-vis the basket of currencies of Israel’s primary trade partners. 2 The interest rate differential is calculated as the difference between the 3-month Tel-bor rate and the 3-month Libor rate, in the main countries that compose the exchange rate index (the US, the euro block, Japan, and Britain). 1 The Economic Sector This disconnect, which began towards the end of 2012, indicates the positive interest rate differential, which represents an incentive for the inflow of financial investments to Israel, does not fully explain the appreciation of the shekel vis-à-vis the basket of currencies that has amounted to 10.2% since August 2012. It is not a new finding, and it is already known from research conducted in Israel and around the world, that the ability of interest rates to explain the path of exchange rates is only partial. And indeed the BoI noted in its interest rate announcement that the strengthening of the shekel vis-à-vis the dollar and the euro in recent months strongly stood out compared to the strengthening of other global currencies in relation to the dollar and the euro. 2 The Economic Sector It must be noted that the trend of appreciation in the shekel occurred during the period in which non-residents had almost fully completed a sell-off of their holdings in the local T-bill (Makam) market3, that is to say the exit of foreign currency from Israel due to the sell-off had greatly reduced. As can be seen in following chart, for a long period the massive sell-off in the T-bill market by non-residents reduced the impact of the inflow of foreign currency for the purpose of direct investments in Israel; and as the sale of Israeli T-bills neared completion, the offsetting effect had weakened. It can be noted that the direct, strategic investments of foreign investors in Israel (primarily, acquisitions of local companies by foreign investors) have been in an upward trend in recent years, and these investments reflect both the preferred status of the Israeli economy over other developed markets that were directly affected by the global financial crisis, and especially the attractiveness of companies from the high-tech sectors in which Israel has a strong comparative advantage. These investments, which do not have any direct link to the natural gas sector, support the trend of appreciation in the exchange rate. It must be added that the amount of direct investments overseas by Israelis has been close to zero. In other words, there are almost no offsetting capital outflows of direct investments overseas by Israelis to the direct capital inflows into the country by foreign investors. Another basic factor contributing to the appreciation of the exchange rate of the shekel is the current account of the balance of payments. The deficit in Israel’s core 3The proportion of their holdings fell to less than 2%, similar to their proportion prior to the period when there began a massive entrance of non-residents to the Israeli T-bill market. 3 The Economic Sector trade account4 narrowed in the fourth quarter of 2012, and in the first quarter of 2013 this account even moved into surplus. The changes in the core trade account stem from a moderation in the demand for investments and for private consumption, which led to a decline in the amount of trade imports. Therefore, basic factors within the real economy can be seen as supporting the appreciation in the exchange rate of the shekel, and thus it is not only the interest rate differential or the impact of local gas production. Regarding the impact of gas production from the “Tamar” gas fields, the BoI announced that foreign currency purchases in the remainder of the year and also in the coming years will be implemented in a manner that will offset the impact of gas production on Israel’s balance of payments and the possible impact on the exchange rate. We point out that from an analysis appearing in the 2010 annual report of the BoI it arises that local natural gas substituted imported fuel in the amount of US$1bn- 2bn per year in recent years, and that the gas fields discovered in the last two years are expected to double the amount to be substituted. That is to say, when the gas substitution will be fully realized, it is expected to amount to US$4bn per year – and this is before the economy begins to export energy. According to BoI estimates, the impact of local gas production (foreign currency payments of gas companies) through the end of 2013 is expected to amount to US$2.1bn, and this is the expected amount of intervention by the BoI in the foreign exchange market. A look back over previous years at the amount of intervention by the BoI in the foreign currency market shows the current decision represents a reduced amount of intervention. As can be seen in following chart, in the years 2008 – 2011 foreign currency purchases by the BoI amounted to US$48bn, that is to say US$16bn per year5. Also, during the period of the BoI’s intervention in the years 1995 – 1997 the intervention of the BoI amounted to more than US$5bn per year. We add that the foreign currency reserves of the BoI stood at US$77bn in April 2013, this compared to a level of US$30bn back before the foreign currency purchases began in July 2008. The BoI declared in the past that the desired level of reserves was between US$65bn- 90bn; yet, according to its last announcement the law permits the central bank to deviate from this target for the purposes of monetary policy. 4 The core trade account is the trade account in the current account of the balance of payments (exports minus imports) excluding volatile components such as ships, aircraft, fuel, and diamonds. 5 From July 2008 through August 2009 the BoI followed a plan involving the purchase of US$100m per day. From August 2009 through July 2011 a plan was implemented allowing an unlimited amount of foreign exchange purchases, in the event of extraordinary fluctuations in the foreign currency market. 4 The Economic Sector The BoI did not note in its announcement a target for the exchange rate; however, an analysis of the real exchange rate of the shekel vis-à-vis the basket of currencies shows that the previous intervention of the BoI in the foreign exchange market occurred when the index of the real exchange rate of the shekel vis-à-vis the basket of currencies crossed above the level of 100 points (an upward rise in this index means an appreciation in the shekel). And as can be seen in Diagram 5, in April the real exchange rate crossed once again the 100 point level, and the reaction of the BoI was not late in coming. The index on the real exchange rate of the shekel vis-à-vis the basket of currencies represents an index on the competitiveness of Israeli exports, since this index in addition to differences in currency rates also weighs price differentials of goods that are exported in Israel and the world. We estimate the BoI is likely to continue to cut the interest rate, especially if there will be a renewed appreciation in the exchange rate of the shekel.
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