Where the Shekel Stops / Terror on the Markets

Speaking at Globes business conference Sunday, Dominic Barton explained purpose of 200 billion euros isn't to help imploding countries repay their debt, but to help countries refinance debt at low interest rate.

As last week ended, the nations of Europe agreed to provide 200 billion euros for an international fund to rescue their own rescue fund. The world read the figure and giggled. To all, it is patently obvious that the sum isn't enough to cover the debts of a giant like Italy or Spain. Except for the managing director of McKinsey. He seems to think otherwise.

Speaking at the Globes business conference on Sunday, Dominic Barton explained that the purpose of the 200 billion euros isn't to help imploding countries repay their debt. It's just to help these countries try to refinance their debts at lower interest rates.

Interest is the name of the game. It always was the name of the game. But until the 2008 crisis, the game was a cinch, as far as countries were concerned. Sovereign bonds were categorized as "risk free," so investors would buy them at very low interest.

That isn't so any more. Fear that the nations won't be able to service their gargantuan debts has sharply increased the interest that the markets demand on government bonds. Interest on Italian bonds spiked to almost 7%. Since Italian economic growth isn't anywhere near 7%, Italy cannot borrow any more - the interest payments alone would ruin it.

This market turbulence has skipped Israel. In stark contrast to Italy, interest on Israeli government bonds remains steady, and low. The Finance Ministry says interest on long-term fixed-income bonds is about 4%, the lowest level Israel has had to pay in a decade, and it's been steady for three years.

The markets are making Israel's life easy, and for good reason. Israel weathered the 2008 crisis practically unmarked: it didn't breach the budget and didn't pile up debt. If anything, Israeli debt has been diminishing.

But also, Israel has a very comfortable monopolistic status in its own bond market. The absolute majority of government issuance, about 80%, is in shekels, on the Tel Aviv Stock Exchange. Since Israelis are the ones buying most Israeli government debt, their risk evaluation is lower - Israelis tend to get less bothered about the geopolitical risk of war.

And, Israelis are largely captive buyers. What are their choices? There have hardly been any new corporate bond issues on the TASE for months. The government is practically the only source of bonds.

There's another reason Israel has a comfortable monopoly in the local bond market. Traditionally, it pampered the people with relatively sweet interest, so the locals didn't seek greener pastures. Four percent may sound lousy compared with Italy's 7%, but over time it's considered pretty good. In the world markets these days, interest above 4% is considered a bad sign.

Actually, Israel pays 4% in real terms, which means plus the CPI, which means it's adjusting for inflation. In global terms, that was huge, before the crisis. These days nothing looks huge any more.

A cultural conundrum

How did Israel's culture of paying high interest rates on bonds become entrenched? Maybe it's the result of years of high inflation, or relatively brisk economic growth over time, so the government could afford it. The high rate places a huge yoke on the state's neck: the percentage of its budget that Israel earmarks for interest payments was among the highest in the world (until the crisis ). At least that yoke pays for Israelis to have more money when they retire, and in any case some 80% of the money paid on interest comes back to Israeli pockets.

That mutual convenience - the state pays its Israeli investors handsomely, who happily buy state bonds - has helped Israel enormously in these hard times. Israel has been spared the terror the markets are inflicting on countries in trouble; it isn't troubled, for one thing, and has its own captive market at home. Predictions that Israel will break through its deficit ceiling in 2012, and will increase issuance by some NIS 14 billion beyond the plan for the year, didn't move the markets at all. Players figure the market can take up the extra issuance without breaking a sweat.

But nothing lasts forever. Think back to June 24, 2002, the day Israel's bond market crashed. Yields on fixed-income Israeli government bonds shot up to 12.5% - yes, almost double Italy's rate and about the rate Portugal has to pay. Those were black days of the second intifada and the bursting dotcom bubble. Israel had sunk into recession and the government deficit was spiraling upward wildly.

In short, the usually placid Israeli bond market showed its wild streak. Israeli investors, fearing Israel was about to default, went for other financial assets, anything but Israeli government bonds.

Israel got the markets' message and instituted emergency measures (the great budget cuts of 2002-2003 ), and persuaded the markets that it had no intention of defaulting. The markets saw and sat back. In retrospect, anybody buying those 12.5% bonds made the best deal of their lives.

But the song remains the same. Captive market or no captive market, the markets will terrorize countries with profligate budget management, showing no mercy.