Is Dr. Fischer Readying a Cure for Israel's Dutch Disease?

The strengthening of the shekel last week is a taste of things to come in the foreign exchange market, unless the central bank acts.

Eytan Avriel
Eytan Avriel
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Eytan Avriel
Eytan Avriel

For those who make their money buying and selling dollars against the shekel, something major occurred last week: The nominal effective exchange rate fell below 85 points for two days.

Why is that important? In the not-too-distant past, when the Bank of Israel routinely intervened in the currency markets to buy dollars and weaken the shekel, it was explained that governor Stanley Fischer and chief currency dealer Barry Topf were basing their decisions on that same nominal effective exchange rate. The index is an average of the shekel's rate against 28 currencies, representing Israel's main trading partners, weighted by trade with those countries.

According to Fischer and Topf's system, the index more accurately reflects market conditions for the shekel than the shekel-dollar rate. That's because the shekel-dollar rate is likely to be influenced by the dollar's direction globally, something the Bank of Israel can't possibly counter.

For the Bank of Israel, there's no sense in reacting to a drop in the dollar around the world, but there's certainly good reason to act when the shekel is strengthening if the source is demand for the currency. Sometimes in the past, when the nominal effective rate fell below 85-86 points (the basket is an index, so it's denominated in points, not one currency or another), the central bank bought hundreds of millions of dollars quickly and changed the market's direction, or at least moderated it.

Remembering this, the heads of currency trading rooms are asking themselves if the Bank of Israel will again buy dollars and, if so, if it's about to start. Or will the bank wait several days to see if the winds change direction.

There's no definitive answer. The central bank doesn't operate by formula. It has no target for the exchange rate on which it makes decisions automatically. Rather, it operates based on how it perceives events and the identity of market participants.

In the past, for example, it didn't hesitate to counter foreign speculators. When it determined that demand was coming from foreign hedge funds and not in reaction to a critical economic event, the bank would enter the market and buy dollars.

Last week, the story changed. The shekel's appreciation against the dollar (and other key currencies) wasn't the response to unusual speculative demand by foreign players. The shekel's rise after Passover stemmed from dollar selling by Israeli exporters, which traditionally occurs at the start and end of every month. They need shekels to pay salaries and taxes.

But this time, when the traditional dollar sellers emerged, there were few dollar buyers to balance them out. The reason is the startup of natural gas production at the Tamar field around the start of the month. And that's the start of the big story for the foreign currency market in 2013.

Tamar's crucial role

According to estimates by the Bank of Israel and private-sector traders, the gas from Tamar will save Israel billions of shekels in foreign currency every year, mainly because there will no longer be a reason for buy mazut (heavy oil) or coal from overseas. In the very near future, the economy will move from a current-account deficit like the one it had last year to a surplus.

This is a dramatic change. Thanks to natural gas, more dollars will come into Israel than will go out. Over time, that spells a creeping appreciation of the shekel versus the dollar and other currencies.

At the beginning of last week, Fischer warned about the so-called Dutch disease. In the 1970s, income from energy resources discovered in the Netherlands caused its currency to take off, wreaking havoc on Dutch exports and the economy as a whole. This did more damage than the energy revenues themselves generated for the country.

Fischer said Israel's government must ensure that our energy income goes to a special fund whose money is invested abroad. So far, nothing has been done to establish the fund, and it's hard to know how politicians will respond to Fischer's call. In any event, it will take time to set up such a sovereign wealth fund, and the pressure on the shekel is being exerted right now.

But back to the dynamics of the forex market. While exporters have to sell dollars to pay salaries, dollar buyers are acting cautiously out of fear the dollar will weaken further, leaving them with losses. The result: They're only ready to buy dollars at the lowest rates, so the dollar is sinking toward NIS 3.60, compared with NIS 4 last summer.

There is a working assumption in the market right now: The flow of Tamar gas has changed the rules of the game and the Bank of Israel will need to do something to stop the strengthening of the shekel. But with home prices rising, the neutral solution of lowering the base interest rate to make the shekel a less attractive currency for investors isn't feasible. Lower borrowing rates would encourage property speculators.

Therefore the market assumes that the central bank will resume intervening in the forex market, as it learned to do in the past, either via regular dollar-buying or by staging periodic commando raids on the market. It may even begin an operation this week, or it may wait to see how the market looks after exporters have ended their monthly shekel buying. Either way, sooner or later the Bank of Israel will have to act.

The experts are convinced of this. The wisest market operators' strategy is based on the assumption that the central bank will intervene but that the inevitability of this has yet to be priced in options contracts.

Why? The standard formula (based on the Black and Scholes model) for pricing sell contracts on dollar put options doesn't take into account intervention, so these contracts are more expensive than they should be. If you're a forex trader and are convinced that the Bank of Israel will halt the shekel's rise, you should be selling your put options against the dollar and take advantage of the high prices. That's exactly what the savviest traders are doing.

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