All That Glitters / Fischer's Commando Raids on the Dollar Market

Foreign investors have been speculating on the shekel mainly by using a financial instrument called a swap; transactions of this ilk, done in one swoop, are remarkably efficient for nonresidents

Bank of Israel Governor Stanley Fischer has one central power: He sets short-term interest rates in Israel, the rate on the shekel. Fischer is not responsible for monetary policy in the United States. Yet with his deputy for market affairs, affairs, Barry Topf, Fischer has caused interest rates on the dollar to rise in the Israeli money market.

Not everybody is pleased about it. Israel's banks, for instance, are howling. "There are no dollars in the market," they wail. "The Bank of Israel is screwing the exporters."

How could the Bank of Israel affect interest on dollars, and is it really doing so to the detriment of corporate Israel?

Foreign investors have been speculating on the shekel mainly by using a financial instrument called a swap. Transactions of this ilk, done in one swoop, are remarkably efficient for nonresidents. They gain from the interest-rate gap between the dollar and shekel, and from capital gains if the shekel appreciates.

The snag is that the volume of such transactions had grown enormous. In the last year, nonresidents bought about 30% of the existing balance of makams (the Israeli equivalent of short-term U.S. T-bills ), equivalent in value to about 10% of Israel's entire output. This activity soaked up much of the dollars in the market.

Consequently, in recent weeks Israel's banks have had difficulty obtaining dollars to lend to clients.

The result has been an increase in the dollar interest rate that the banks charge each other and their clients.

Even for good companies, ones with basically no credit risk, interest on dollar loans has reached Libor + 1.25%. At the end of last week, 3-month Libor was 0.3% a year, which meant the interest rate on the dollar in Israel had reached about 1.55%. That's an increase of half a percent in the space of a few weeks.

What does Fischer have to do with this? It's what he didn't do.

Israel's banks would like Fischer to resolve the shortage by depositing his many dollars with them, not in overseas banks, which is his preference at this time. Alternatively, the banks would like Fischer to sell them one-year forward contracts, or to impose the new liquidity requirements on foreign currency transactions on non-bank entities as well.

Declaring war

The banks are angry because the high cost of dollar interest in Israel is losing them deals. "The Bank of Israel is screwing exporters and small foreign trade companies. It's raising their cost of foreign currency derivative transactions," complained a top officer at a big bank late last week.

Fischer has suffocated the dollar credit market so badly that it's increasing Israel's risk premium, which is a bad thing, says the banker.

But is that so? According to people at the Bank of Israel, the bankers' complaints are biased. "If you take $100,000 that you got from your American uncle to an Israeli bank, you'll find the interest they offer you is zero," said a central banker. "If the banks want to bring in foreign currency, let them offer better terms."

The truth is that the Bank of Israel has nothing to apologize for. It doesn't have to explain what's been happening in the forex lending scene. What's happening is exactly what the central bank wanted to happen. When Fischer and Topf saw the gargantuan extent of makam purchases by nonresidents, they went to war, using every weapon in the book and some that probably aren't.

They imposed new liquidity requirements on the banks regarding swap and forward transactions. They persuaded the Finance Ministry to abolish the exemption nonresidents had on capital gains from makams and deposits. They forced a host of irritating new reporting requirements on the banks and the forex speculators, and now they're drying up the foreign currency credit market - precisely in order to jack up interest on foreign currency loans.

From the Bank of Israel's point of view, the moment it costs nonresidents more to fund foreign currency deals in Israel, the less it pays for them to speculate on the Israeli market. Their entire motivation to do transactions of the sort in Israel melts. In the view of the Bank of Israel, it's a huge victory: There's no question that raising interest on the dollar locally is one of the reasons that enabled the governor to raise the monetary interest rate by 0.25% for January, to 2.25%.

Will the moves manage to halt the flow of speculative money to Israel? At this stage, mere weeks after the Bank of Israel started landing blow after blow on the forex market, that's a clear-cut absolute Yes. But will this effect hold?

In a short period of time, the exchange rate of the dollar rose from just above NIS 3.50 to just under NIS 3.70. Even if the central bank received an unexpected helping hand from the Egyptian crisis, the trend change looks significant. Meanwhile, local forex players say that in the last three weeks, about $2.5 billion worth of short positions on the dollar have been wound down, meaning some people reverted from bets against the dollar.

Both Fischer and Chilean central bank governor Jose De Gregorio, who visited Israel last week, say that intervening in the forex market is not terribly efficient, nor is it normally advisable. The only problem is, it's necessary, Fischer added.

We may assume that Fischer would prefer not to perpetuate the absurdity of having one interest rate for local investors and another for nonresidents. But just like during the great crisis of 2008, Fischer is now afraid of a double whammy, perhaps even a triple one: weak export markets abroad combined with geopolitical developments that lead defense officials to clamor for more money, combined with the shekel rising against the dollar and other currencies.

There's nothing Fischer can do about the first two risks, but he sure can against the third, and he will fight it with all his might, including commando raids on the local dollar credit market.