The Shekel's Story

Reading the business pages, do you have that nasty feeling that you missed out? Yes, I mean you: you abhor risk and hunkered down in savings accounts, bank deposits or at the absolute most, in fixed-income Shahar bonds. When the war hit in July, you probably patted yourself on the back for your conservatism, for choosing to hold your money in deposits of property, not to take superfluous risks.

Yet not three months have passed since the Hizbullah stopped raining missiles on northern Israel, and the Tel Aviv Stock Exchange is breaking record heights again. From the start of 2006 Tel Aviv stocks have gained 8%, and the smallcaps have soared by some 40%. Real estate stocks gained no less than 75%.

But if your money is squatting in deposits or other low-risk savings vehicles, the volatile stock market is not your benchmark.

Mazal tov

In this era of global investments, when you can invest just about anywhere you'd like and pay the same rates of tax on gains, your yardstick is bonds and deposits in the international marketplace.

And you're in for a surprise. It turns out that Israeli government bonds have provided just about the best possible returns in the last five years.

According to Morgan Stanley, which tracks returns on bonds the world wide, with the exception of Colombias currency, Israeli government fixed-income Shahar bonds are the best investment to be had the world wide.

Much of the surplus yield on Shahars was racked up this year. In shekel terms the Shahar climbed 6%. But when their ascent is measured in dollars, the return is doubled, because of the shekel's appreciation. From the start of the year, the shekel has strengthened by 7% against the dollar and 4% against the basket of currencies.

The dollar-shekel from the start of 2005

In the past, pundits tended to associate the shekel's strength to the Bank of Israel's painful disinflationary policies, which involved keeping real interest rates sky-high. The high interest rates, invoked to fight inflation, created a façade of financial stability, the explained: the day inflation and interest rates dropped, Israelis would flee shekel assets for the forex market, shooting down the shekel and destabilizing the economy.

And when the Bank of Israel and Finance Ministry liberalized the currency market and enabled any Israeli who so desired, to invest abroad, down to his last sou, some wailed that financial doom was imminent.

It was not. They were wrong, as turned out two years ago, when the Finance Ministry carried out the last phase of the liberalization, and lowered capital gains tax on foreign assets to the same level as capital gains tax on Israeli assets. Tax parity triggered the same wails of woe: investors will stampede abroad and devastate the local market, warned the pundits.

And here we are, with the year 2007 approaching fast, with a wide- open marketplace, unfettered, and with practically no tax protectionism. Any citizen or institutional can invest money in bonds or deposits in other countries too; yet the shekel is standing firm as a rock.

Mushrooming foreign investment

Why? Simple. It boils down to economic fundamentals: low inflation, low budget deficits, a small deficit in the balance of trade, and a great surplus in the balance of payments. Not many countries have fundamentals like these.

In the last year something strange and wonderful has been happening, strange at least in the eyes of local market vets who've been playing the odds for two or three decades. The strange and wonderful thing is foreign analytical coverage, by mutual funds and hedge funds, of the shekel.

It turns out that much of the shekel's strength in the last year has been due to a massive influx of foreign money, mainly by strategic investors who believe in Israeli companies for the long-term, but also by financial investors seeking quick profits.

In the last year alone, foreign investment in Israel has passed $20 billion. Proportional to GDP, that's the highest level of foreign investment in the world. For comparison, foreign investors in China reached $85 billion this year, which is equivalent to 2% of GDP.

Having foreign investors in Israeli hi-tech, and the involvement of multinationals in foods, industry and in telecommunications, has become the norm.

The savviest investors in the world

But the idea that hedge funds, the savviest investors in the world, who have a whole globe to choose from, place the shekel on their investment menus, is revolutionary for long-timers in the local marketplace. We were more used to thinking of ourselves as a Chosen People surrounded by enemies, with unique economic rules, and to assuming that our currency would never become an integral part of the international markets.

Why were "they" selling us that thesis? To justify deviation from responsible economic policy that adhered to international norms. They claimed these norms didn't apply here.

But they do and it turns out that when we do apply international norms, the results do arrive, even though we're stuck in a bad neighborhood of the Middle East.

Historic events

A month ago a historic event happened in the local financial market, though the media hardly noticed. The State of Israel issued unlinked 20-year Shahars.

People had assumed for years that the Israeli government couldn't issue unlinked notes for more than a few years, because of the regional instability, the "special nature" of the Israeli economy, our chronic inflation, and the risks.

Yet it turns out that the market is ripe for unlinked 20-year paper. Astonishingly enough, the yield, which is a function of risk, namely - 5.81%, is very close to the yield on shorter 5-year bonds (5.53%).

Capital losses on a 20-year unlinked note can hurt badly. Anybody buying the 20-year bond is betting that Israel will preserve responsible economic policy as a way of life.

The good news is that even with the threats of Iran from the east, Hizbullah from the north and crumbling public confidence in the Israeli government's ability to formulate and pursue strategic policy decisions, at least in the financial arena, we have achievements, relying on economic policies that do not assume that different rules apply to the people of Zion.

But there is more news. The might of the shekel and of the Israeli economy rely more and more on the tremendous traffic of foreign investors investment. These streams could strengthen as the American economy slows and western investors seek returns. But the emerging markets have a history of volatility and crises. That backwind lifting us high could reverse at the same startling speed.