Hard Landing / Why the Dollar Sank on Wednesday

The dollar just keeps rising. In July 2008 its exchange rate sank to a low of NIS 3.20, but since then it's been steadily creeping upward, closing at NIS 4.25 last Tuesday. So from July to last Tuesday, the American currency appreciated by 33% against the shekel. Then come Wednesday, the dollar suddenly weakened by 1% and on Friday it fell even further, going below NIS 4.2.

What happened? Why did the dollar suddenly sink? The answer: Purim.

Or, to put it otherwise, the Bank of Israel was closed for the holiday.

The Bank of Israel has become the dominant player in Israel's currency market.

Since last summer, it's been buying $100 million each business day, with remarkable consistency and precision. Market players have adjusted their activities to the daily dosage of dollar acquisitions by the central bank.

On Wednesday, the Bank of Israel's dealing room was closed for Purim, so the usual order to buy $100 million didn't come through. Hence the dollar fell.

Don't worry. On Thursday and Friday the Bank of Israel was back in business as usual. But the market's reaction to that one-day hiatus shows starkly just how dominant the central bank has become in the dollar-shekel scene.

The rise of the dollar against the shekel hasn't been the only effect that the Bank of Israel's purchasing has had. Since it began to soak up dollars, volatility in the forex scene has diminished. The volume of dealing has also dropped. The entire foreign currency market has become a calmer, more predictable place.

The standard deviation of the dollar exchange rate, which measures market volatility and nervousness, dropped from 22% before the era of the central bank purchasing, to just 12% today.

"Before, if a bank were to buy $50 million from a customer, it would get stressed and quickly pass it through the system. The money would roll from one to the next and send everyone into a tizzy," a trader said.

"Now, the bank just sits tight and waits for the Bank of Israel's purchase order, and sells it the dollars. The rest of the financial world may be in complete upset, and currency values are seesawing up and down. Over here, it's quiet. Even a little dull."

So let's see. The governor of the Bank of Israel, Stanley Fischer, managed to pull a rabbit out of his hat. He has achieved all the goals he set when announcing last summer that the central bank would be buying dollars on the market.

b He has lowered the value of the shekel and somewhat improved the situation of exporters, who were collapsing under the weight of the global crisis and the strong shekel.

b He has increased Israel's foreign currency reserves to more than $40 billion.

b He has somehow managed to smooth out the market, making it more stable.

b He has moderated the drop in prices and eased the fear of deflation, by increasing the cost of exports (because of the increase in the dollar against the shekel).

b He has even made a lot of money for the central bank. Say the Bank of Israel bought $20 billion at an average exchange rate of NIS 3.80. In shekel terms it's earned about $2 billion, which is real money for the state. For that move alone, Fischer gets a 10.

Every success has its price, and dangers lurk here too. The question in Israeli forex circles is when Fischer will stop buying dollars every day. Another is what will happen to the shekel-dollar rate when he does.

Every speculation strategy in town is based on a single gamble - when the Bank of Israel will stop buying foreign currency, at which point, speculators figure, the shekel will bounce up. Sophisticated speculators have been buying long-term options that will make them a killing if the dollar suddenly drops.

But Fischer has no reason to gratify the speculators, and they may be in for a disappointment. First of all, based on the Bank of Israel's statements that it's aiming for foreign currency reserves of $44 billion, it has $3 billion to go.

At its present pace, that's about two months, not including sabbaths and holidays.

Secondly, maybe Fischer will continue to buy dollars after that point - perhaps smaller sums or less frequently, but still.

And third, nobody can tell whence the dollar in world markets. Maybe it will strengthen against other currencies, and therefore it will appreciate against the shekel even if the Bank of Israel isn't buying any more.

The news reports about the American economy may be terrible, but the dollar has regained its status as a safe haven for the world investment community.

The worse the financial crisis becomes, and the sharper the drops in world markets, the more demand for the dollar has increased. When the markets stabilize and start to rebound, the dollar is likely to lose some ground, but probably not much. Traders simply feel that the euro, British pound and yen are worse off.