Israel Faces Capital Influx When It Joins Bond Index

Inclusion in Citi index likely to pressure shekel higher, frustrating Bank of Israel efforts.

Mixed denomination Shekel currency banknotes sit on display in this arranged photograph at Israel's central bank in Jerusalem, Israel, on Monday, Aug. 19, 2013.
Ariel Jerozolimski, Bloomberg

Investment bank Citi is expected to include Israel in its influential World Government Bond Index in coming months, a boost for the local bond market but a potential headache for the central bank as it fights to contain the surging shekel.

An estimated $3 trillion of assets track Citi’s index. Israel would account for less than 0.5% of it, but it nonetheless could mean an influx of up to $4 billion of foreign money into the market.

That may add to the appreciation of the shekel, which is already near a 15-year high versus the euro, a 2-1/2 year peak against the dollar and its strongest level ever against a basket of foreign currencies. Further strengthening could be a big problem for a trade-focused economy like Israel’s.

Israel is now $1 billion to $2 billion short of the $50 billion index eligibility threshold for outstanding government bonds, a gap Citi’s analysts believe will close within a few months. An analysis this month from Bank of America Merrill Lynch said inclusion could come as early as June, while Citi emerging markets strategist Luis Costa estimates five to six months.

“The fact that there would be more demand for Israeli securities is a good thing. It will help liquidity, tradability of the securities ... it could lower the yields needed to issue government bonds,” said a senior Israeli government official, who spoke anonymously.

The impact could be particularly strong, however, because only about 5% of domestic bonds are owned by foreign investors, meaning there is a lot of room for new money.

“Israel is one of most developed markets in terms of bonds,” said Hani Shitrit Bach, head of the listing and economics department at the Tel Aviv bourse. “Here the market is open to everyone, it’s not an over the counter market like overseas.”

Tal Levi, fixed income director at Halman-Aldubi investment house, reckons WGBI inclusion could mean low interest rates for longer.

Bond trade volumes may rise substantially, he said, but a stronger shekel would further hurt exporters and leave Israel “trapped” at near zero interest rates.

Plus, real yields in Israel are attractive. For long-term government bonds, they are around 2%, compared with flat and negative yields in many developed countries.

Bank of America Merrill Lynch said the Bank of Israel might need to begin a dedicated currency intervention program to balance out the inflow from foreign bond buyers.

The central bank, which has been buying on average $830 million of foreign currency a month to keep the exchange rate in check, declined to comment.