Europe’s Negative Interest Rate Spells Trouble for Israel

The European Central Bank’s dramatic step will force the Bank of Israel to respond, putting the economy at risk of real estate and stock market bubbles.

Nir Keidar

He’s still not done, European Central Bank President Mario Draghi said over the weekend, regarding plans to stimulate the eurozone economy and fight off deflation. “We think it’s a significant package,” Draghi told reporters. “Are we finished? The answer is no.”

Of all of his comments, that’s the one that attracted the attention of economists, traders and bankers, and generated most of their speculation over the future.

Understandably, the headlines focused on the practical steps that the European Central Bank took: lowering the deposit rate that European banks receive for keeping money with the central bank to a negative 0.1%, meaning that they will have to pay for the privilege, as well as a new liquidity program. The traders, however, are more interested in knowing what the central bank will be doing down the line, after it becomes clear that even the latest measures don’t deliver the goods.

European commentators have dubbed the latest plan “swarm,” meaning a flood of money. It’s the big step that everyone was expecting for weeks, and its declared purpose is clear: doing everything possible to cause the banks to stop holding on to their money and instead lending it to clients to jumpstart the sputtering European economy and head off a spiral of declining prices.

But will it actually work? Although the plan attracted kudos for its monetary daring, most commentators remain skeptical, believing that the day is not far off when the European Central Bank will need to take further steps in dealing with the crisis. No one is talking about even steeper negative interest rates, so the thinking is that the next phase would involve steps similar to those taken by the U.S. Federal Reserve. That would include buying up bonds of all shapes and kinds to inject more money into the banking system and ultimately force the banks to lend to small and medium-sized businesses (since large enterprises are still getting bank loans).

So does all this affect Israel? Absolutely. The Israeli economy is totally open and based on foreign trade. Europe is our largest trading partner, so what happens there affects us, too. The low European interest rates, for example, can be expected to drive traders to look elsewhere - including Israel - to put their money. Interest rates here are historically low but at 0.75% it’s high by developed world standards. The influx of funds will only strengthen the already dangerously strong shekel further.

Since the Israeli economy is also slowing a bit, this is a nightmare scenario for the Finance Ministry and Bank of Israel. For their part, Israeli exporters are planning a media offensive against a strong shekel, since it makes Israeli exports less price-competitive abroad. Technology companies launched their broadside offensive on Sunday and I would bet that we will be reading about other manufacturers pleading for government assistance while threatening layoffs and plant closures over the strong shekel.

It has to be assumed that the Bank of Israel will lower interest rates soon, probably by 0.25 percentage point to 0.5%. But what then? It’s hard to stop a trend like this. When interest rates are negligible in Europe, the United States and Japan, when Israel has its own budgetary challenges, when exports and private sector employment here are stagnant, no one can promise that interest rates in Israel won’t be lowered further and that we, too, won’t be looking at negative interest rates. And then what?

With bank deposits and government bonds paying such low rates, Israeli interest rates are effectively in negative territory already after adjusting for inflation. But what will Israelis do with the 3 trillion shekels ($866 billion) in financial assets that they have when even nominal shekel interest rates approach zero? It’s hard to predict, but here are some guesses:

1. Money will be withdrawn from banks

According to Bank of Israel data from last week, Israelis still have 53 billion shekels in bank deposits, another 100 million shekels in checking accounts and more than half a trillion shekels in short-term deposits. When the banks tell depositors that interest rates are zero, some will look for other places to put their money as long as it generates some kind of return. And where might that be?

2. People will buy more apartments

Although the housing market is in a waiting mode to see whether Finance Minister Yair Lapid’s plan to exempt first-time buyers of new construction from value-added tax actually goes through, we can assume that ultimately some Israelis will decide to buy real estate, whether it is a first, second or third home. Mortgage interest rates will also drop . The return on investment in residential real estate will be low — perhaps just 2% to 3% — but that’s still better than what the banks would offer. And many Israelis relate to investment in a home as they do to putting money away in a pension or as their children’s inheritance. The result will be that home prices go up.

Some people think Lapid’s plan alone will be enough to increase demand for housing and thereby push up prices. If we add to the brew a collapse in interest rates, the direction of home prices is all but sealed.

Economists will warn against paralyzing the economy for the sake of the real estate sector and say that the real solution is freeing up massive amounts of land for new residential construction. In the interim, however, the housing price bubble will continue to inflate. That also means that anyone who does not already own a home will find it even more difficult to buy one. And Israelis will increasingly be exposed to the vagaries of the housing market against the backdrop of increased risk of a financial and real estate crisis in the future, when housing prices finally drop to reasonable levels. We’ve seen the effects of such price collapses in Europe and the United States.

3. Money will gravitate to the stock market

Money will be put into shares and corporate bonds. In the United States there is an almost perfect correlation between the amount of money being printed and share prices. Negligible interest rates and growing money supply pump up stock and bond markets for the simple reason that people have nowhere else to invest their money.

Many analysts have long been convinced that corporate bond prices have been totally divorced from the level of risk they represent. On the other hand, no argument can win out against a torrent of money looking for better returns. If bank deposits are redirected to the securities market, it will only exacerbate these market distortions. The big winners will be smaller companies issuing stock and companies with risky bond offerings.

4. Private consumption could rise

If your money isn’t drawing any interest, maybe you might as well buy something that you can enjoy with it. For those who have the wherewithal, they may boost their spending on cars, household furnishings and cultural and leisure activities. The rise in real estate prices may also give some homeowners the sense that they’re richer and also encourage them to spend.

5. Inequality will increase

In theory, low interest rates should serve the interests of the weaker segments of the population by enabling them to borrow money cheaply, to refinance, buy property and benefit from low consumer credit costs. In practice, however, it’s those with means who are the primary beneficiaries because it boosts real estate and stock market prices, and that benefits people who own homes and investment portfolios. On the other hand, people who are having trouble making ends meet don’t get bank loans so they cannot easily benefit from low interest rates.

The American experience shows that an economy that is growing slowly and at the same time is using cheap money to inflate real estate and securities bubbles presents the perfect recipe for a big widening in economic inequality.