In a step that caught the markets by surprise, the Bank of Israel moved decisively Monday to stem the strengthening of the shekel, announcing a two-pronged program to buy $2.1 billion in foreign currency this year and reducing its base lending rate by a quarter of a percentage point to 1.5%.
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The central bank said it was compelled to act out of concern that the Israeli currency’s appreciation against the dollar is damaging Israel’s economy by eroding the price competitiveness of its key export sector.
The shekel has been on the ascent for more than a year, but it has been given an extra boost by speculators and from the beginning of natural gas production at the Tamar field offshore. The domestic gas supplies will reduce Israel’s need to import energy, saving dollars.
“Natural gas production in Israel is causing an improvement in the current account, which is leading to appreciation pressures on the shekel. This phenomenon, often referred to as ‘Dutch disease,’ is liable to negatively impact Israel’s economy,” the bank said in a statement.
The shekel weakened sharply on Tuesday, losing 1.9% against the dollar to a Bank of Israel rate of NIS 3.6380. Against the euro, the Israeli currency weakened even more, by more than 2% to NIS 4.7294.
The shekel has appreciated 2.4% against the dollar in the past month and 5.4% in the past three months, a development that had prompted the central bank to intervene four times in the foreign currency market since the start of April to try and stem the rise. The Bank of Israel spent some $540 million in the effort but largely to no avail.
Meanwhile, pressure was mounting on the shekel after central banks in Europe, Australia and elsewhere lowered their lending rates in the last few days. The European Central Bank cut its rate two weeks ago by a quarter point to 0.5% while Australia’s Reserve Bank this week lowered its rate by a similar amount to 2.75%.
That widened the interest rate spread between the shekel and other key currencies, giving an added incentive to speculators to buy and hold shekels.
The interest rate reduction, which goes into effect on Friday, was the central bank’s first unscheduled rate cut since the start of the global financial crisis at the end of 2008. The bank traditionally adjusts rates once a month, announcing a new rate, if any, the final Monday before the final Thursday.
But Uri Greenfeld, an economist at Psagot Investment House, said surprise was a central element of bank Governor Stanley Fischer’s strategy. “It appears that the Bank of Israel is interested in creating a surprise effect in order to maximize its impact on the forex market,” Greenfeld said. “The consensus had been that he would lower the rate at the end of this month.”
Major policy change
As to the long-term intervention, Greenfeld said it marked a significant change of policy for the central bank which had previous regarded intervening in the market as something it would do only when the rate failed to reflect economic fundamentals. Only a few months ago, the Bank of Israel was asserting that the flow of gas wasn’t expected to influence the exchange rate. On Monday, however, the bank said it would continue the foreign-currency buying program beyond 2013, until the government sets up a sovereign wealth fund for its natural gas earnings.
The bank said it arrived at the $2.1 billion figure by calculating how much dollar savings the gas from Tamar, which began production at the end of March, would yield. It said that would add about $2.8 billion to Israel’s balance of payments this year.
By buying foreign currency, the central bank is scooping up excess supply of the dollar and other foreign currency. The unscheduled interest rate cut also is designed to reduced demand for the shekel by narrowing the interest rate differential between Israel and other economies.
Fischer had other reasons for wanting a rate cut. The 2013-14 budget now winding its way through the cabinet and later the Knesset will hurt consumer spending with its package of tax hikes and spending cuts. A rate cut should help compensate by lowering the cost of credit.
But by lowering the rate, however, Fischer risks a new surge in housing prices by reducing the cost of taking out a mortgage. The bank admitted as much in its announcement Monday, but asserted that other measures it has taken over the last several months to restrain mortgage demand should counteract the effect of low interest rates.
“The decision by the Monetary Committee was intended to deal with the entire economy and establishes a balance between considerations influencing various sectors,” the Bank of Israel stated. “We would stress that the actions taken by the banks supervisor in the field of mortgages reduce the effect of the monetary interest rate on the housing market.”