Taking Stock / Spending the Guarantees

Depositors in Israel's provident funds, pension funds and various insurance savings schemes knew a moment of gratification last week. The cause for this gratification was reports of the yields the funds generated in the first half of 2003 - 5-10 percent in real terms.

Stocks make headlines; but the instruments responsible for the institutional investors' profits were government bonds traded on the Tel Aviv Stock Exchange.

In the first half of the year, bond prices have soared. Highly leveraged long-term bonds have jumped by as much as 20 percent, while short- and medium-term bonds have increased by 5-10 percent.

Rising bond prices are the mirror image of the steep drop in interest rates. When bond prices rise, yields (interest) drop, and vice versa.

Interest on Shahar bonds sank from 12 to 8 percent; and interest on CPI-linked Galil bonds tumbled from 6 to 4.5 percent. This is not only one of the sharpest about-turns in the capital market, it is also one of the only points of light in the economy. Most borrowers could not have long survived the insanely high interest rates that prevailed at the start of the year.

Why did interest rates fall?

Which begs a few questions: What led to that sharp interest rate drop? Will it persist? How can interest rates of all types and kinds, which are still terribly high, be brought even lower?

The main reason interest rates have dropped so sharply is the reduction in the risk associated with Israel, stemming from America's heightened involvement in the region - from the conquest of Iraq, to imposing the road map on Israel and the Palestinians, and the hudna.

Another reason is Benjamin Netanyahu's economic program, which has made the public feel that after years of reckless fiscal irresponsibility, there's a firm hand at the treasury willing and able to institute real change.

But note that even after the budget cuts, the conquest of Iraq and the resumption of the peace process, there is a very big problem. The government's deficit is running at 6 percent of GDP - its highest level in a decade. And next year's deficit is looking no less elephantine.

Note that short-term, real Bank-of-Israel interest is still running at 6-7 percent (a height rarely reached before), based on the central bank's apprehension that the risk inherent in the markets is still high.

Ergo, if all the factors mentioned above were what lowered the interest rates, they did so only by virtue of influencing investors' expectations - because there has been no improvement at all in economic growth, the deficit, investments, or in any other relevant economic parameters. None whatsoever.

Wait! There is one substantial, quantitative and immediate change worthy of note - those $9 billion in American loan guarantees. Israel's treasury means to raise $3 billion through U.S.-backed bond issues on foreign markets soon enough.

A fundamental misunderstanding

Several analysts recently claimed that Israel didn't need those guarantees. Israel - unlike Argentina, for example, and other countries reduced to acute financial crisis - has practically no foreign debt; nor is its balance of payments any cause for worry. We do not need foreign currency aid, they point out. The external debt structure is long-term and convenient, and the nation is armed with hefty foreign currency reserves.

But their conclusion is very wrong. Israel does need those loan guarantees - badly. The government doesn't need foreign currency; but it does need shekels to finance its NIS 30 billion deficit this year.

The $3 billion that the treasury will raise will immediately be deposited at the Bank of Israel, against which the accountant-general will withdraw NIS 13.5 billion to finance the deficit until year-end 2003.

Since the accountant-general has already figured out how to finance the deficit this year, the treasury dramatically reduced debt issues in the local bond market. For the first time in years, the treasury's net debt offerings in the home market will apparently be zero.

Which leads us to the most important question of all: Did interest drop in recent months because the government stepped down debt issues in the local market thanks to the loan guarantees? Or, was it because of investor anticipation of economic changes over the long run - reduced government expenditure and fiscal restraint?

Well, there's the Bank of Israel's version, and the treasury's. Yet you might be surprised by their positions.

The Bank of Israel's opinion was evident in an interview Dr Adi Brender gave to Haaretz this week. He claimed that the way the deficit was financed did not affect interest rates. The main issue was the public's expectations regarding the budget deficit and short-term Bank of Israel lending rates, he claimed.

Deputy accountant-general Eldad Frecher, who also handles the bond issues abroad, believes that the Bank of Israel's stance is supported by theory; but in the capital market reality, the factor that counts is supply and demand of bonds.

Since the treasury dramatically reduced the supply of bonds in the local marketplace, based on the expected guarantees, the immediate result is a drop in interest rates.

On one thing, the central bank and treasury do agree: This is the first time Israel's economy needs American aid, although it doesn't need foreign currency. It is the first time the entire purpose of the aid is to finance shekel budget deficits.

We went on a spree, and the Americans are paying the bill.