Opinion |

Bank of Israel's Love of Dollars Inflicts Heavy Tax on Israelis

The central bank buys dollars and maintains near-zero interest rates to protect exporter and producer profits. Is the price the public pays for this worthwhile?

Eytan Avriel
Eytan Avriel
Bank of Israel chief Karnit Flug presenting the new 200-shekel bill, December 2015.
Bank of Israel chief Karnit Flug presenting the new 200-shekel bill, December 2015. Credit: Emil Salman
Eytan Avriel
Eytan Avriel

Last Thursday could have been a holiday for Bank of Israel Governor Karnit Flug – or at least an opportunity to break into a small smile. Due to the U.S. Federal Reserve raising interest rates, the shekel was up more than 1% against the dollar, improving the situation of Israeli exporters and industrialists in the so-called global currency war. Right?

Wrong. The Bank of Israel and Flug never consider the dollar exchange rate to assess the shekel’s situation – and it’s easy to understand why. While the shekel weakened against the dollar, it strengthened by a similar margin against the Euro, the currency of the countries to where Israel exports more than to the United States.

Bank of Israel officials are most concerned with the figure known by the nonuser friendly “effective exchange rate index,” which looks like a rolling disaster. In the past six months, the shekel has strengthened against this basket of currencies by no less than 6%, around 14% since mid-2015 and 23.7% over the past decade.

As far as Flug and her colleagues are concerned, issues like concentration in the banking industry, the high cost of living, house prices pushing young couples out of the market, economic inequality, poverty and being last in education among OECD nations are secondary, or beyond their scope of responsibility. In contrast, they lose sleep over the shekel’s consistent strengthening against other currencies.

The central bank’s policy is well known. It is prepared to do almost anything to support exporters and industrialists, who profit more from a weak shekel. Just two weeks ago, the central bank purchased about $250 million on the foreign exchange market, to halt the shekel’s strengthening that day. It has purchased over $60 billion since 2008, expanding Israel’s foreign currency reserves to $97 billion. This is a mind-blowing amount for such a small country.

The Bank of Israel also maintains near-zero interest rates (0.1%, to be exact), even though it pushes housing prices skyward. Why? Because raising interest rates is liable to strengthen the shekel further. Central bankers are even waging a war of words: Andrew Abir, head of the central bank’s Market Operations Department, told Bloomberg, “The currency is still notably overvalued,” and that “exports are still growing more slowly than world trade.”

Rony Gitlin, head of spot trading at Bank Leumi (the country’s second-largest lender), discerned from Abir’s comments “that the central bank won’t disappear from the Forex market,” Bloomberg reported.

The bottom line is clear. The Bank of Israel protects exporters and industrialists – at any price.

But what if the central bank is wrong? Perhaps this policy is too costly for Israeli citizens, and the Bank of Israel should stop buying dollars and keeping near-zero interest rates? Or at least this policy should be reevaluated? Below are some of the main considerations against this policy, and the central bank’s responses to these claims.

1. A weak shekel increases the cost of living

A weak shekel greatly increases the cost of living in Israel and levies a tax on its citizens. This is easily understood. If the dollar would be 3.10 shekels instead of 3.80 shekels, all imports would be 20% cheaper for households. Cars, trips abroad, electronics, home appliances and just about everything we buy – save for fresh food and local services – would be 15-20% cheaper. It would be a huge jump in the standard of living for the public, which is forced to yield to the central bank in favor of exporters and industrialists.

Bank of Israel counterargument: First, the rise of the shekel will cause the closure of factories and local production, mainly low-tech plants. The result will be the unemployment of tens of thousands of workers. Second, Israel doesn’t have a problem with a high cost of living and private consumption. It’s a fact that Israelis buy cars and imported consumer products like crazy.

2. The Bank of Israel is subsidizing inefficient factories

The Bank of Israel is effectively subsidizing exporters and producers, artificially sustaining inefficient businesses and factories that have no economic justification to exist. In the past, Israel has maintained a host of inefficient industries through import quotas, but it realized its mistake about 20 years ago. When imports opened, most of Israel’s textile industry and other industries dependent upon cheap labor closed. Thousands of people were fired. However, it paid off: The economy transitioned to making products with a higher added value; it grew faster; and the laid-off workers were quickly absorbed into other industries. The conclusion was that even if a wave of layoffs would occur and the state had to assist thousands of unemployed people, the economy would benefit in the mid- and long-term. It is worth forcing shaky companies to become more efficient.

Bank of Israel counterargument: All countries, save the United States, make an effort to weaken their currency to support export and local production, and to deal with global markets. It is irresponsible to do the reverse.

3. Buying dollars exacts a price

There is evidence that buying dollars and holding foreign currency reserves exacts a very high price from the economy, some of it complicated. First, there is constant trading in the Forex market because the central bank amasses dollars, creating a risk to people saving for their pension. This risk stems from the fact that institutional investors need foreign currency purchases to hedge against investments in foreign securities. Institutional sources estimate that the price of this basic risk (the gap between the present price and the price charged in futures contracts) costs us all 1% in annual returns on pension savings. That is a lot of money. Second, the Bank of Israel actually thwarted itself. Because it has a near-$100 billion Forex investment portfolio, and because it issued short-term, shekel-denominated bonds against this portfolio, raising interest rates would cause it enormous losses and would look very bad in central bank reports.

Bank of Israel counterargument: We are not a commercial bank, and we can absorb accounting losses to support the economy, business activity and employment.

4. A strengthening shekel won’t hurt high-tech

When discussing damage to exports, some fear for high-tech – which for years was the engine of the economy. However, a strengthening shekel won’t hurt startups and exits, or serious companies producing a higher added value. Despite the relative rise in dollars to employ Israelis, most R&D centers in Israel are looking for brains and ideas, and don’t produce or conduct calculations on profits and losses.

Bank of Israel counterargument: Intel’s factories are Israel’s greatest exporter. A significant change in exchange rates could cause the U.S. company not to open more Israeli plants.

5. The central bank’s incentive is not effective

If you want to help unemployed people or factories that are national priorities, it’s better to do so in a focused fashion, and not through a general tax on the cost of living in Israel.

Bank of Israel counterargument: The budget blanket is short. It’s unclear if budgets will be found for this.

6. Perhaps exports don’t depend on exchange rates?

Do exports depend on the shekel’s value? What seems obvious is actually anything but. A look at a shekel-dollar graph compared to annual export growth suggests no correlation. In contrast, there is a clear correlation between Israeli exports and measures of global trade activity. Additionally, the troubling question has arisen more than once of whether the central bank’s acquisition of dollars makes any impact, midterm or long-term, on the shekel rate. Many think not. They explain that buying dollars is a drop in the Forex trading sea. For them, the fact that the shekel continues to strengthen, despite all the purchases, proves them right.

Bank of Israel counterargument: We bought tens of billions of dollars in recent years, which remain in the Bank of Israel foreign currency account. If we hadn’t, these funds would circulate through the market and certainly strengthen the shekel – albeit it’s impossible to estimate by how much. Anyway, we don’t try to set the shekel rate but rather moderate volatility and slow its strengthening down – and it’s a fact that it is strengthening.

7. Some benefit from a stronger shekel

Some production and export companies actually benefit from a strong shekel, because the cost of raw materials, mostly imported, decline. Such a result can happen in a place where a company has a leading product and can compete price-wise when production costs decline. It would be great to have more of these companies.

Bank of Israel counterargument: None.

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