Defending the Shekel Will Come at a Cost

Exporters and others who are suffering under the strong shekel want to have the best of both worlds: a strong economy and a weak currency. So should the central bank set a floor for the shekel?

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After recovering at the start of the year, the dollar is again losing ground to the shekel, rekindling the debate over what the Bank of Israel should be doing to prevent the exchange rate from wreaking havoc on the economy.

On Monday the U.S. dollar lost 0.26% to a Bank of Israel rate of 3.4880 shekels. The question facing the forex markets and policy makers is whether the central bank and its governor, Karnit Flug, should set a floor for the shekel, either based on the dollar or the currency basket.

A critical question that is asked less often is whether the Bank of Israel should intervene to support the Israeli currency, at a cost of tens of billions of shekels.
Two countries have acted in recent times to support their currency – Switzerland and the Czech Republic – whose central banks declared they would support their currencies at any price, setting a ceiling for how far they would let them appreciate against the euro.

The Swiss franc had strengthened 26% in the two years before the Swiss National Bank drew its red line. It had lowered its base lending rate to almost nil and the economy was at risk of deflation before it acted just over two years ago.
 The Czech Republic actually did suffer deflation before it instituted its forex rate policy two months ago, with the financial assistance of the International Monetary Fund and the Organization for Economic Cooperation and Development. In November alone, the Czech National Bank spent the equivalent of 5% of gross domestic product to defend the crown.

In the past year, the Israeli shekel has appreciated 6.8% against the dollar, 3.3% against the euro and 7.6% against the basket of currencies.

That makes the shekel a good candidate for intervention, but if the Bank of Israel followed the Czech route, the cost would amount to some 50 billion shekels ($14.3 billion). Is Israel prepared to put out the sum, knowing that it might not be sufficient?

Such a policy would have to have the broad support of the public as well as the prime minster, the Finance Ministry and the Knesset. It would cost the central bank heavily because it would need to issue short-term notes, whose holders are paid a higher rate of interest than what the central bank will get on the dollar holdings it will be accumulating.

All signs indicate that Flug will not set a floor for the shekel-dollar or shekel-basket rate despite widespread calls to do so. That doesn’t mean she is against the idea in principle, as her predecessor Stanley Fischer was, but she is highly aware of the risk.

The extent of Flug’s power within the Bank of Israel is also a factor. The bank has undergone a changing of the guard from the Fischer-Flug team to the Flug-Sussman team. The majority of the Bank of Israel’s monetary committee, its chief policy-making body, are Fischer appointees, such as Rafi Melnick, Reuven Gronau and Alex Cukierman. Only Sussman is a Flug appointee. Once a deputy governor is chosen by Flug, she will have two allies on the panel plus herself evening up the forces, but for now she doesn’t have a built-in majority for any move, particular one fraught with risk.

Flug also has to contend with the strength of the economy and market forces, both of which are acting to increase the value of the shekel. The global financial crisis has ignited currency wars, like the ones that Switzerland and the Czech Republic have been fighting.

Exporters and others who are suffering under the strong shekel want to have the best of both world: a strong economy and a weak currency. But those two phenomena rarely come together.

Three years ago, when the shekel was even stronger than it is today, Eli Yones, then the CEO of Mizrahi-Tefahot Bank, said the economy would have to get used to a dollar exchange rate of 3.30 shekels.

That view is advocated by economists such as Avi Ben-Bassat, a former top Bank of Israel and treasury official, who say policy makers should let the market decide the exchange rate and the economy will adjust, a view shared by most of these in power now. Under this view, intervening in the market won’t work.

Yet other experts, such as Jonathan Katz, chief economist of Leader Capital Markets, don’t rule out the possibility that the Bank of Israel will ultimately set a floor through intervention and lowering the interest rate, as the Czechs did. There is also a powerful lobby supporting intervention. Zvi Oren, who heads the Israel Manufacturers Association of Israel, has called for a floor of 3.80 shekels to the dollar. Even if intervening to create the rate costs billions of shekels, he argues, failure to do so will cost the economy still more.

Exports have all but imploded, growing just 1% in 2012 compared with 5% in 2011. In picture: Loading a ship with containers for export.Credit: Bloomberg

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