Central Bank Cans Currency Basket

The Bank of Israel will stop publishing the representative rate for its basket of currencies starting May 1. The central bank yesterday announced it was taking this step, because the exchange rate had ceased to be followed or serve as an analytical tool since it did away with the exchange rate band 18 months ago. The bank will no longer calculate the rate on an ongoing basis nor update the balance of weighted currencies. Other currency rates will continue as usual.

The representative rate for the dollar has fallen 11.5 percent against the shekel over the past year, while the euro has slid just 1.1 percent. The basket of currencies rate has dropped 8.5 percent during this period, because the dollar was weighted 75 percent.

The basket of currencies is supposed to reflect the country's foreign trade. Is 75 percent of its foreign trade conducted in dollars? Central bank studies reveal that such is not the case. Though 75 percent of trade contracts are registered in dollars, a great deal of these contracts are done with countries in the eurozone. Thus, the prices are linked more closely to the euro. Analysts believe the dollar's true share of the trade is 40 percent, while the euro's stake is about 30 percent. The dollar has an advantage with exports, but the euro has an edge on imports. If the shekel's appreciation against currencies worldwide was adjusted to reflect its true trade of balance, it would be significantly less than 8.5 percent.

The local economy indeed measures itself almost exclusively in dollars, so it sees the 11.5 percent appreciation over the past year, even if in reality the local currency has strengthened much less. This dollar orientation has serious consequences for inflation. An artificial reduction of inflation to below the government's target stemmed mainly from the shekel's appreciation against the dollar and the fact that the Israeli economy orients itself toward the dollar and ignores other currencies.

Thus, measuring up against the dollar or a dollar-dominated basket of currencies artificially lowered inflation last year. This drop, needless to say, does not make the central bank comfortable. It led to criticism of the bank for missing its 2006 inflation target.

One can surmise that the central bank is seeking ways to manage this criticism. Among other things it will try to have the shekel reflect a more realistic picture against a true basket of currencies that is not dollar dominated. The central bank announced in the first stage it would stop publishing the basket's representative rate. More time is needed to see whether the Bank of Israel will try to publish another rate in its stead, which would give a more accurate expression to the basket of currencies reflecting Israel's true trade.