Who Should Be Concerned if Interest Rates Go Up, and Who Would Benefit?

With growth sluggish and a strong shekel, expect the Bank of Israel rate to remain low for now.

Emil Salman

At the end of July, while large numbers of Israel Defense Force troops were operating in Gaza, Bank of Israel Governor Karnit Flug decided to lower the base interest rate again, this time to 0.5%. That restored the rate to the low it had reached in 2009 in the midst of the global financial crisis.

As with prior rate reductions, the most recent one was attributed to sluggish economic growth as well as the weak export picture, which in part is the result of the strength of the shekel. The war situation also contributed to the decision.

Many are of the opinion that at 0.5%, the interest rate has more or less hit bottom. True, there are still economists who believe that we will see one more interest rate reduction, to 0.25%, but even if that happens, it’s hard to believe that it will do anything for the local economy.

The lowering of rates to such a level, similar to rates prevailing in other Western countries, would be made possible for one main reason – the absence of inflationary pressures. With inflation running at close to zero and even concerns about deflation, interest rates can hover at negligible levels. The question is how much longer rates can remain so low without inflationary pressures beginning to push them upward.

It’s possible that the answer may actually come from abroad. At the end of July, Jan Hatzius, the chief economist at the American investment bank Goldman Sachs, surprised when he revised his March forecast and predicted that the United States Federal Reserve Bank would already begin raising interest rates in the third quarter of next year. That’s half a year earlier than Goldman Sachs had originally projected, and stems mostly from a drop in unemployment in the U.S. and strong macroeconomic figures.

An increase in U.S. interest rates, if and when it happens, would be a dramatic event that would probably force the Bank of Israel to respond in a similar fashion. Even if the time for this appears distant, the world economy has experienced other surprises and a hike in rates could happen sooner than economists think.

Israel was scathed relatively little from the global economic crisis and was the first country to raise interest rates – in 2010, when Stanley Fischer was the central bank governor. And while rates in markets in the developed world remained close to zero, in August 2011 the Bank of Israel’s base rate was up to 3.25%. Later, following slowing economic growth, the absence of inflationary pressures and the strength of the shekel, the base rate was gradually lowered to its current level.

Good for banks, bad for investors

As a rule, investors in shares and bonds don’t like it when interest rates are raised. It increases the attractiveness of government bonds and suppresses demand for corporate stocks and bonds. In addition, a return to rising interest rates could hurt a number of publicly-traded companies and affect their ability to borrow money and increase their financing costs.

Rising rates would particularly hurt highly-leveraged companies that rely on regular credit and could also harm the real estate sector, including developers and construction firms. But not all companies are created equal. Just as increased interest rates hurt businesses that rely on credit, it could help companies that provide credit, first and foremost the banks.

Among the regular consumers of credit are the real estate investment trusts, or REITs, and income-producing real estate firms. Cheap money is like a drug to income-producing real estate companies because it enables them to acquire assets and rent them out at a nice profit, which is based on the difference between the cost of credit and the price that they get from renting out properties, less the cost of running them. Interest rate hikes therefore can dramatically increase their costs.

Holding companies at the top of corporate pyramids can also be hurt by rising interest rates, as can other holding companies that rely heavily on credit. The greater the extent of leveraging on the part such companies, the more rising interest rates do damage.

The main holding companies traded on the Tel Aviv Stock Exchange are the Delek Group, the Israel Corporation, IDB Development and Discount Investment. There are also smaller holding companies such as Kardan N.V., Elbit Imaging, Israel Land Development, Zur Shamir Holdings and Africa Israel Investments. The most leveraged of them, based on the relationship between their equity and their balance sheet, are Discount Investment, Kardan and the Israel Corp.

Developers of residential property are also likely to be hurt by rising interest rates, but for reasons different from firms specializing in income-producing property. By increasing the cost of mortgage loans to members of the public, rising interest rates could substantially reduce demand for housing. Smaller construction firms that don’t have a major cushion of capital could be particularly hurt. Residential developers have another problem in that they have had trouble raising funds on the bond market even in a low-interest environment.

In addition to the large number of real estate developers, including Azorim, Shikun & Binui, Ashtrom and B. Yair, the special position of the Mizrahi Tefahot bank should also be mentioned. Nearly 50% of its portfolio is in the mortgage and real estate sectors, so a downturn in residential real estate and difficulties in the mortgage loan industry could hurt its profits and stock price.

On the other hand, the banking sector in general could benefit from rising rates in that its major source of income is derived from interest charged their customers. The bread and butter of the business is based on the difference between the interest the banks charge on loans and what they pay in interest from savers, from the Bank of Israel and on bonds that the banks issue. When prevailing interest rates are low, they are forced to make do with low profit margins.

Furthermore, notes Lilach Shafir-Friedland, a vice president at the Halman Aldubi investment firm, banks come out winners when interest rates go up because that is likely to take place at a time when the economy is also on the upswing. “A growing economy has a positive effect on the business turnover of the banks as providers of credit,” she notes.

The timing of the increase in interest rates is also significant. If the Bank of Israel embarks on a path of increasing rates before other central banks do, it could strengthen the shekel in relation to other currencies, particularly the dollar. That could hurt export-related businesses, whose products become more expensive and less competitive, or are forced to cut their profit margins and may even be driven into the red.

The shekel strengthens as interest rates rise here, because foreign capital flows in to take advantage of the rates. Investors from abroad purchase shekels in the process and drive up its value. The average Israeli consumer benefits from a strong shekel, however, as it makes imports less expensive in shekel terms and reduces the cost of vacations abroad. And importers such as the Castro fashion chain stand to benefit from a strong shekel.

Dozens of publicly-traded export-related companies could be hurt by a stronger shekel. Companies that report their results in dollars but have expenses that they pay in shekels are among the potential losers. They include Adama, the agricultural chemical company formerly known as Makhteshim Agan; Israel Chemicals; El Al Israel Airlines and the energy firm Ormat Technologies.

Shafir-Friedland notes that companies whose profit margins are already low are particularly vulnerable in a climate of rising interest rates.