Bank of Israel’s Forex Intervention Comes Under Fire

The only alternative to intervention is to lower interest rates, but base rate is already at a historic low and dropping it further would fan the flames of an already overheated residential real-estate market.

Mixed denomination Shekel currency banknotes and coins sit on display in this arranged photograph at Israel's central bank in Jerusalem, Israel, on Monday, Aug. 19, 2013.
Ariel Jerozolimski, Bloomberg

An unusual meeting took place quietly at the end of last week where a clutch of top officials asked some fundamental questions about a key Bank of Israel policy, namely its longstanding policy of regularly intervening in the foreign currency market to prevent the shekel from strengthening.

The central bank has been buying dollars since 2008, accumulating in the process a mountain of greenbacks that now amounts to $96.5 billion, up from about $25 billion before the policy got under way.

Until now, however, critics of the bank’s policy have been confined mainly to academia, including Profs. Adi Pozner and Omer Moav. However, one of those academics is Avi Simhon, who earlier this year became chairman of the National Economic Council and Prime Minister Benjamin Netanyahu’s chief economic adviser.

In a cabinet session a month ago, Simhon publicly attacked the Bank of Israel’s policy of forex intervention. He was instrumental in initiating last week’s meeting of policy makers, which included Bank of Israel Governor Karnit Flug; Eli Groner, director general of the Prime Minister’s Office, treasury chief economist Yoel Naveh and Prof. Natan Zussman, the central bank’s head of research.

Only a week ago, Flug publicly defended the policy, saying that in an era when many of the world’s central banks are engaged in a currency war, all trying to prevent their respective currencies from strengthening, Israel was in no position to withdraw.

“Most central banks around the world are adopting very accommodative monetary policies that are acting, among other things, to weaken their currencies, and these measures are creating distortions in the global exchange-rate system,” Flug told a press conference.

“This situation may lead to an erosion of profitability among many businesses in Israel to an extent that will not allow them to survive this period . When foreign exchange markets return to equilibrium, it’s likely that these businesses will not reopen.”

The intervention policy is designed to offset the impact of the current account revolution that has occurred in Israel since 2000.  Israel exports more goods and services than it imports, and more recently with the start of natural gas productions has slashed its energy-import bill. Israel attracts billions of dollars every year in foreign investment.

The intervention policy has kept the shekel from appreciating as it should; in fact, the currency has shown a slight real depreciation of 3% since 2000.

Defenders of the policy say that if the shekel were subject to market forces it would strengthen to the point that many exporters, including the country’s vaunted high-tech sector, would no longer be able to compete in overseas markets.

The only alternative to intervention is to lower interest rates, but base rate is already at a historic low of 0.1% and dropping it further would fan the flames of an already overheated residential real-estate market.

Simhon regards intervention as tantamount to a protective tariff that raises prices for consumers by deterring import competition. Industry suffers as well because a strong shekel raises the cost of raw materials and imported capital goods that deter investment and make it harder for the economy to raises productivity growth.

Simhon argues that the only exports that would be harmed by an appreciating the shekel are those that are marginally profitable and that most Israeli industry could weather an appreciation of 10%. All in all, Simhon estimates that no more than 40,000 jobs would be lost directly from an appreciation and that many of those would be regained as improved consumer purchasing power increased household spending, which would create more employment.

Defenders of intervention say job losses would amount to more than 40,000 and that the jobs that would disappear are relatively high-paying.