Some economists are predicting the start of economic rebound this very year, but for now the Bank of Israel intends to continue buying dollars.
Speaking on Tuesday at an International Monetary Fund conference in Jerusalem, Bank of Israel Governor Stanley Fischer said that the policy of buying dollars, which the treasury implemented last year, had proven itself. The purchases are especially important now in light of the great global economic instability, Fischer said.
When the Bank of Israel started buying dollars in mid-2008, its stated aim was to beef up Israel's foreign currency reserves by $10 billion, to roughly $44 billion at most. It's reached that place, approximately. But evidently Fischer has no intention of stopping the purchases.
Some analysts think the central bank may have to stop soon anyway, due to change in the circumstances. For instance, suggests Michael Sarel, head of the Economics and Research Department at Harel Insurance Investments and Financial Services, the Bank of Israel would stop the purchases if the shekel starts to rapidly lose value, or if inflation expectations shoot up.
At the conference, Fischer also swung his attention to the deficit, and painted a frightening picture. This year he sees the deficit rising to 6% of gross domestic product. In 2010 he sees the deficit receding, but just a little, to the equivalent of 5.5% of GDP.
Increasing the deficit beyond those levels would be wrong, Fischer stressed. Some suggest that if the deficits are already as big as they are, why not increase them further, he said: "The answer is that we have no way of financing them. Those are children's games and we won't play these games."
A deficit of more than 6% of GDP spells trouble, he emphasized.
Israel's ratio of debt to gross domestic product is already too high, Fischer said. The Maastricht Treaty defines the appropriate level as 60%, and Israel's isn't even close.
Israel gained a lot of brownie points by reducing its debt-GDP ratio drastically in recent years, from more than 100% to around 80%. It shouldn't squander that credibility by allowing the ratio to balloon again, Fischer urged.
Meanwhile, Michael Sarel of Harel sees no signs of recovery in the broader economy. He suspects the government will run a deficit of NIS 88 billion this year and next, combined. The government will have to finance most of that gargantuan deficit by issuing bonds in the local market, which could have the effect of depressing bond prices.
However, the the Bank of Israel has already announced that it would buy NIS 15 billion to NIS 20 billion worth of government bonds over the next few months, which would help buttress the bond market.
Also, some of the deficit can be financed through borrowing overseas, by issuing bonds backed by U.S. loan guarantees.
"The main problem is that the government will have to slash the 2010 budget by NIS 14 billion, according to Finance Ministry estimates, to keep the deficit from exceeding 5.5% of GDP," Sarel writes.
Unpopular steps will have to be taken, such as abolishing tax exemptions and increase of indirect taxes, although at this stage the Finance Ministry has not yet quantified the amounts needed.
"The prime minister and finance minister face brutal battles within the cabinet and in Knesset over the next few weeks to achieve deep cuts in the 2010 budget. If they fail, the budget deficit and huge government bond issues that will be needed to finance it will be even greater, which could raise Israel's risk premiums and long term interest rates," Sarel writes.
He doesn't buy the Bank of Israel forecasts of zero or negative inflation in 2009. That forecast does consider recession and shrunken demand, but ignores the effect of aggressive monetary policy that the central bank itself implemented in recent months, for instance by lowering its overnight rate to 0.5%.
Its policy sharply increased the money supply and supported the devaluation of the shekel. Those forces countered the deflationary pressure caused by the recession, he explains.
Sarel estimates that inflation will reach 1.9% in the coming 12 months.
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