It's Hard to Stop Riding a Tiger

No economist knows what the 'correct' rate is. BOI chief Fischer does not know, either. The 'correct' rate can only be determined by the market.


About two and a half years ago, Governor of the Bank of Israel Stanley Fischer became the public's darling. At that time, Fischer decided to intervene in the foreign currency market with the aim of raising the shekel-dollar exchange rate.

The exporters praised him. High-tech executives bowed down before him. Manufacturers Association President Shraga Brosh shook his hand warmly and told him to stick with it. Journalists crowned him a king. Others said he had taught the politicians what leadership was and how to take responsibility.

Fischer began intervening in the foreign exchange market on March 20, 2008. He announced then that the Bank of Israel would buy foreign currency to the tune of $25 million per day and would accumulate $10 billion within two years. The declared intention was to increase Israel's foreign currency reserves from $28 billion to $38 billion. But the primary aim was something else - raising the shekel-dollar exchange rate.

When several months had passed without any improvement in the exchange rate, the governor announced in July 2008 that $25 million a day was insufficient, and he would switch to a purchase rate of $100 million per day. What does this recall? Someone who is addicted to drugs. At first, he makes do with 25 milligrams a day. But when his body has gotten used to that, he needs to inject himself with 100 milligrams a day. Otherwise, he will suffer withdrawal symptoms.

In August 2009, the Bank of Israel began a rehabilitation program. It said it would stop purchasing a fixed amount of dollars every day, but would continue to intervene in the market and buy dollars if the market was not functioning properly.

Following this huge purchase of dollars over two and a half years, Israel's foreign currency reserves rose to the very high level of $65 billion, instead of the planned $38 billion. In other words, Israel has an excess of $27 billion, which is difficult to maintain. It costs the bank (that is to say, the country ) hundreds of millions of shekels every year. For on one hand, the bank earns almost no interest on these dollars. But on the other hand, it pays high interest on the shekels it borrows from the public in the form of treasury bills.

The other price of this policy is capital losses in the billions, because the bank bought the dollars at a higher exchange rate than the current one. And since the shekel-dollar exchange rate is expected to continue falling, the bank is expected to suffer further losses.

But the losses are not the main problem. The main problem is the trap into which Fischer fell with open eyes. He tried at one and the same time to keep inflation low and to maintain the profitability of exports.

These, however, are contradictory aims. Because in order to stop inflation, you have to raise interest rates. But if you want to maintain export profitability - which requires a high exchange rate - you cannot raise interest rates, because a high shekel interest rate attracts investors who sell dollars and buy shekels. That causes the dollar's exchange rate to fall, which harms the profitability of exports.

The result of this trap is that we wound up with the worst of both worlds. Because it now turns out that we still have inflationary pressures, which are reflected in both apartment prices and share prices on the stock exchange. But we also have a low exchange rate that harms exports.

No central bank governor in the world can prevent the exchange rate from dropping for a prolonged period. The rate is determined by the weakening of the dollar worldwide, by the growth in exports, and by the interest rate differential, which attracts investors to Israel who sell dollars.

Therefore, there is no place for intervention. A freely floating exchange rate serves as a shock absorber for the economy: The exchange rate's ups and downs prevent crises. But if one intervenes to try to achieve a "correct rate," the end result will be a collapse.

No economist knows what the "correct" rate is. Fischer does not know, either. The "correct" rate can only be determined by the market.

So if people in the Bank of Israel nevertheless think they know what the "correct" rate is, they should change the bank's name to the Speculation Bank of Israel. And speculation, as we all know, ends badly.

It would therefore have been better not to have embarked on this wild spree in the first place. It was popular in the short run, but very costly and ineffective in the long run. For when one rides a tiger, the big question is how to get off without being swallowed up. And this appears to be an impossible task.